A Look At The Fair Value Of Cenovus Energy Inc. (TSE:CVE)

Does the October share price for Cenovus Energy Inc. (TSE:CVE) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the foreast future cash flows of the company and discounting them back to today's value. I will be using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for Cenovus Energy

Step by step through the calculation

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.

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

	2020	2021	2022	2023	2024	2025	2026	2027	2028	2029
Levered FCF (CA$, Millions)	CA$1.67b	CA$1.40b	CA$1.04b	CA$1.17b	CA$1.06b	CA$998.7m	CA$963.0m	CA$944.5m	CA$937.3m	CA$937.8m
Growth Rate Estimate Source	Analyst x9	Analyst x7	Analyst x3	Analyst x2	Est @ -9.33%	Est @ -5.94%	Est @ -3.58%	Est @ -1.92%	Est @ -0.76%	Est @ 0.05%
Present Value (CA$, Millions) Discounted @ 9.1%	CA$1.5k	CA$1.2k	CA$800	CA$825	CA$685	CA$591	CA$522	CA$469	CA$426	CA$391

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$7.4b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 10-year government bond rate of 1.9%. We discount the terminal cash flows to today's value at a cost of equity of 9.1%.

Terminal Value (TV)= FCF₂₀₁₉ × (1 + g) ÷ (r – g) = CA$938m× (1 + 1.9%) ÷ 9.1%– 1.9%) = CA$13b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$13b÷ ( 1 + 9.1%)¹⁰= CA$5.5b

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$13b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of CA$11.7, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

The assumptions

We would point out that 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 Cenovus Energy 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 9.1%, which is based on a levered beta of 1.208. 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.

Next Steps:

Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For Cenovus Energy, I've put together three essential aspects you should look at:

1. Financial Health: Does CVE have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
2. Future Earnings: How does CVE'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 High Quality Alternatives: Are there other high quality stocks you could be holding instead of CVE? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

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

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.