Stock Analysis

# An Intrinsic Calculation For MEG Energy Corp. (TSE:MEG) Suggests It's 35% Undervalued

•  Updated

In this article we are going to estimate the intrinsic value of MEG Energy Corp. (TSE:MEG) by estimating the company's future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Believe it or not, it's not too difficult to follow, as you'll see from our example!

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

See our latest analysis for MEG Energy

### 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. 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, and so the sum of these future cash flows is then discounted to today's value:

#### 10-year free cash flow (FCF) forecast

 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 Levered FCF (CA\$, Millions) CA\$1.69b CA\$1.14b CA\$865.6m CA\$722.2m CA\$641.8m CA\$594.7m CA\$567.0m CA\$551.2m CA\$543.0m CA\$539.9m Growth Rate Estimate Source Analyst x5 Analyst x6 Est @ -24.35% Est @ -16.57% Est @ -11.13% Est @ -7.33% Est @ -4.66% Est @ -2.79% Est @ -1.49% Est @ -0.57% Present Value (CA\$, Millions) Discounted @ 7.8% CA\$1.6k CA\$985 CA\$692 CA\$536 CA\$442 CA\$380 CA\$336 CA\$303 CA\$277 CA\$256

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA\$5.8b

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. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (1.6%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 7.8%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = CA\$540m× (1 + 1.6%) ÷ (7.8%– 1.6%) = CA\$8.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA\$8.9b÷ ( 1 + 7.8%)10= CA\$4.2b

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\$10.0b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of CA\$21.0, the company appears quite undervalued at a 35% 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

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 MEG 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 7.8%, which is based on a levered beta of 1.460. 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.

### Moving On:

Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. 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. 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 MEG Energy, we've compiled three important factors you should explore:

1. Risks: For instance, we've identified 5 warning signs for MEG Energy (1 is potentially serious) you should be aware of.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for MEG's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
3. Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

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.

### Valuation is complex, but we're helping make it simple.

Find out whether MEG Energy is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.

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