Is Africa Oil Corp. (TSE:AOI) Trading At A 29% Discount?

Key Insights

• Africa Oil's estimated fair value is CA$3.52 based on 2 Stage Free Cash Flow to Equity
• Africa Oil's CA$2.50 share price signals that it might be 29% undervalued
• Our fair value estimate is 10% higher than Africa Oil's analyst price target of US$3.19

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Africa Oil Corp. (TSE:AOI) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

See our latest analysis for Africa Oil

The Method

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	US$147.0m	US$109.5m	US$89.5m	US$78.6m	US$72.3m	US$68.7m	US$66.7m	US$65.7m	US$65.4m	US$65.6m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Est @ -18.26%	Est @ -12.20%	Est @ -7.96%	Est @ -5.00%	Est @ -2.92%	Est @ -1.46%	Est @ -0.45%	Est @ 0.27%
Present Value ($, Millions) Discounted @ 7.3%	US$137	US$95.0	US$72.4	US$59.2	US$50.8	US$44.9	US$40.6	US$37.3	US$34.6	US$32.3

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$604m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.9%. We discount the terminal cash flows to today's value at a cost of equity of 7.3%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$66m× (1 + 1.9%) ÷ (7.3%– 1.9%) = US$1.2b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$1.2b÷ ( 1 + 7.3%)¹⁰= US$609m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$1.2b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of CA$2.5, the company appears a touch undervalued at a 29% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at Africa Oil as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we've used 7.3%, which is based on a levered beta of 1.082. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

SWOT Analysis for Africa Oil

Next Steps:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Africa Oil, there are three important elements you should assess:

1. Risks: To that end, you should be aware of the 2 warning signs we've spotted with Africa Oil .
2. Future Earnings: How does AOI's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
3. Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

PS. Simply Wall St updates its DCF calculation for every Canadian stock every day, so if you want to find the intrinsic value of any other stock just search here.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.