Is Precision Drilling Corporation (TSE:PD) Trading At A 49% Discount?

Key Insights

• Precision Drilling's estimated fair value is CA$202 based on 2 Stage Free Cash Flow to Equity
• Current share price of CA$103 suggests Precision Drilling is potentially 49% undervalued
• Analyst price target for PD is CA$124 which is 39% below our fair value estimate

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Precision Drilling Corporation (TSE:PD) as an investment opportunity 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. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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.

View our latest analysis for Precision Drilling

Crunching The Numbers

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) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CA$, Millions)	CA$284.2m	CA$335.0m	CA$315.5m	CA$271.0m	CA$262.0m	CA$257.9m	CA$256.6m	CA$257.2m	CA$259.2m	CA$262.1m
Growth Rate Estimate Source	Analyst x9	Analyst x9	Analyst x2	Analyst x1	Analyst x1	Est @ -1.57%	Est @ -0.50%	Est @ 0.24%	Est @ 0.77%	Est @ 1.13%
Present Value (CA$, Millions) Discounted @ 10%	CA$258	CA$275	CA$235	CA$183	CA$161	CA$143	CA$129	CA$118	CA$107	CA$98.4

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$1.7b

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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 10%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$262m× (1 + 2.0%) ÷ (10%– 2.0%) = CA$3.2b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$3.2b÷ ( 1 + 10%)¹⁰= CA$1.2b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is CA$2.9b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of CA$103, the company appears quite good value at a 49% 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

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 Precision Drilling 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 10%, which is based on a levered beta of 1.804. 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 Precision Drilling

Moving On:

Whilst important, the 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. 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 Precision Drilling, we've put together three essential factors you should further examine:

1. Risks: You should be aware of the 4 warning signs for Precision Drilling (1 shouldn't be ignored!) we've uncovered before considering an investment in the company.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for PD'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. 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.