Is There An Opportunity With Athabasca Oil Corporation's (TSE:ATH) 31% Undervaluation?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Athabasca Oil fair value estimate is CA$6.00
• Athabasca Oil is estimated to be 31% undervalued based on current share price of CA$4.16
• The CA$5.25 analyst price target for ATH is 13% less than our estimate of fair value

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Athabasca Oil Corporation (TSE:ATH) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. It may sound complicated, but actually it is quite simple!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

See our latest analysis for Athabasca Oil

The Method

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, 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 (CA$, Millions)	CA$282.0m	CA$248.3m	CA$229.5m	CA$218.6m	CA$212.6m	CA$209.7m	CA$209.0m	CA$209.7m	CA$211.4m	CA$213.8m
Growth Rate Estimate Source	Analyst x4	Analyst x3	Est @ -7.60%	Est @ -4.74%	Est @ -2.74%	Est @ -1.34%	Est @ -0.36%	Est @ 0.33%	Est @ 0.81%	Est @ 1.14%
Present Value (CA$, Millions) Discounted @ 7.5%	CA$262	CA$215	CA$184	CA$163	CA$148	CA$136	CA$126	CA$117	CA$110	CA$103

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$1.6b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 7.5%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$214m× (1 + 1.9%) ÷ (7.5%– 1.9%) = CA$3.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$3.9b÷ ( 1 + 7.5%)¹⁰= CA$1.9b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is CA$3.4b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of CA$4.2, the company appears quite undervalued at a 31% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Athabasca 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 7.5%, which is based on a levered beta of 1.123. 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 Athabasca Oil

Next Steps:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Can we work out why the company is trading at a discount to intrinsic value? For Athabasca Oil, there are three relevant items you should further examine:

1. Risks: For example, we've discovered 1 warning sign for Athabasca Oil that you should be aware of before investing here.
2. Future Earnings: How does ATH'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the TSX every day. If you want to find the calculation for other stocks 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.