Is There An Opportunity With Kelt Exploration Ltd.'s (TSE:KEL) 47% Undervaluation?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Kelt Exploration fair value estimate is CA$11.95
• Kelt Exploration's CA$6.30 share price signals that it might be 47% undervalued
• Kelt Exploration's peers seem to be trading at a lower discount to fair value based onthe industry average of 29%

Today we will run through one way of estimating the intrinsic value of Kelt Exploration Ltd. (TSE:KEL) by taking the forecast future cash flows of the company and discounting them back to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Believe it or not, it's not too difficult to follow, as you'll see from our example!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

View our latest analysis for Kelt Exploration

The Calculation

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. In the first stage we need to estimate the cash flows to the business over the next ten years. 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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CA$, Millions)	-CA$23.8m	CA$39.5m	CA$59.2m	CA$80.3m	CA$100.7m	CA$119.3m	CA$135.5m	CA$149.2m	CA$160.7m	CA$170.3m
Growth Rate Estimate Source	Analyst x3	Analyst x3	Est @ 49.84%	Est @ 35.51%	Est @ 25.48%	Est @ 18.46%	Est @ 13.55%	Est @ 10.11%	Est @ 7.70%	Est @ 6.01%
Present Value (CA$, Millions) Discounted @ 7.1%	-CA$22.2	CA$34.4	CA$48.2	CA$60.9	CA$71.3	CA$78.9	CA$83.6	CA$85.9	CA$86.4	CA$85.5

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$613m

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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 7.1%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$170m× (1 + 2.1%) ÷ (7.1%– 2.1%) = CA$3.4b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$3.4b÷ ( 1 + 7.1%)¹⁰= CA$1.7b

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$2.3b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of CA$6.3, the company appears quite good value at a 47% 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.

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Kelt Exploration 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 7.1%, which is based on a levered beta of 1.100. 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 Kelt Exploration

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it 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. 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. What is the reason for the share price sitting below the intrinsic value? For Kelt Exploration, we've compiled three important factors you should look at:

1. Risks: For instance, we've identified 2 warning signs for Kelt Exploration that you should be aware of.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for KEL's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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.