MEG Energy Corp.'s (TSE:MEG) Intrinsic Value Is Potentially 88% Above Its Share Price

Key Insights

• MEG Energy's estimated fair value is CA$47.66 based on 2 Stage Free Cash Flow to Equity
• Current share price of CA$25.29 suggests MEG Energy is potentially 47% undervalued
• Analyst price target for MEG is CA$26.50 which is 44% below our fair value estimate

How far off is MEG Energy Corp. (TSE:MEG) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the forecast future cash flows of the company and discounting them back to today's value. This will be done using the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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 MEG Energy

The Model

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 begin with, we have to get estimates of 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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CA$, Millions)	CA$1.01b	CA$973.0m	CA$952.8m	CA$944.2m	CA$943.6m	CA$948.4m	CA$957.1m	CA$968.5m	CA$982.1m	CA$997.2m
Growth Rate Estimate Source	Analyst x8	Analyst x1	Est @ -2.08%	Est @ -0.90%	Est @ -0.07%	Est @ 0.51%	Est @ 0.91%	Est @ 1.20%	Est @ 1.40%	Est @ 1.54%
Present Value (CA$, Millions) Discounted @ 8.3%	CA$936	CA$830	CA$751	CA$687	CA$635	CA$589	CA$549	CA$513	CA$481	CA$451

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$6.4b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (1.9%) 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 8.3%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$997m× (1 + 1.9%) ÷ (8.3%– 1.9%) = CA$16b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$16b÷ ( 1 + 8.3%)¹⁰= CA$7.2b

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$14b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of CA$25.3, the company appears quite undervalued at a 47% 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.

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 8.3%, which is based on a levered beta of 1.280. 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 MEG Energy

Next Steps:

Although the valuation of a company is important, 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. 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 MEG Energy, we've compiled three essential factors you should look at:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with MEG Energy , and understanding this should be part of your investment process.
2. Future Earnings: How does MEG'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.