- Oil and Gas
Estimating The Fair Value Of Paramount Resources Ltd. (TSE:POU)
- Paramount Resources' estimated fair value is CA$33.3 based on 2 Stage Free Cash Flow to Equity
- Current share price of CA$30.0 suggests Paramount Resources is trading close to its fair value
Does the February share price for Paramount Resources Ltd. (TSE:POU) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
Check out our latest analysis for Paramount Resources
We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) forecast
|Levered FCF (CA$, Millions)||CA$388.5m||CA$373.0m||CA$370.4m||CA$370.4m||CA$372.3m||CA$375.6m||CA$379.8m||CA$384.6m||CA$390.1m||CA$395.9m|
|Growth Rate Estimate Source||Analyst x2||Analyst x2||Est @ -0.70%||Est @ 0.01%||Est @ 0.52%||Est @ 0.87%||Est @ 1.12%||Est @ 1.29%||Est @ 1.41%||Est @ 1.49%|
|Present Value (CA$, Millions) Discounted @ 9.0%||CA$356||CA$314||CA$286||CA$262||CA$242||CA$224||CA$208||CA$193||CA$179||CA$167|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$2.4b
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 5-year average of the 10-year government bond yield of 1.7%. We discount the terminal cash flows to today's value at a cost of equity of 9.0%.
Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = CA$396m× (1 + 1.7%) ÷ (9.0%– 1.7%) = CA$5.5b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$5.5b÷ ( 1 + 9.0%)10= CA$2.3b
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$4.8b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of CA$30.0, the company appears about fair value at a 9.9% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
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 Paramount Resources 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 9.0%, which is based on a levered beta of 1.218. 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 Paramount Resources
- Debt is not viewed as a risk.
- Dividends are covered by earnings and cash flows.
- Earnings growth over the past year underperformed the Oil and Gas industry.
- Dividend is low compared to the top 25% of dividend payers in the Oil and Gas market.
- Shareholders have been diluted in the past year.
- Annual revenue is forecast to grow faster than the Canadian market.
- Current share price is below our estimate of fair value.
- Significant insider buying over the past 3 months.
- No apparent threats visible for POU.
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. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Paramount Resources, there are three additional elements you should look at:
- Risks: Case in point, we've spotted 3 warning signs for Paramount Resources you should be aware of.
- Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for POU's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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.
Valuation is complex, but we're helping make it simple.
Find out whether Paramount Resources 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.View the Free Analysis
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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.
Paramount Resources Ltd. explores for and develops conventional and unconventional petroleum and natural gas in Canada.
Outstanding track record with excellent balance sheet.