An Intrinsic Calculation For Pembina Pipeline Corporation (TSE:PPL) Suggests It's 37% Undervalued

By
Simply Wall St
Published
February 13, 2021
TSX:PPL
Source: Shutterstock

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Pembina Pipeline Corporation (TSE:PPL) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. 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 Pembina Pipeline

The model

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. 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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
Levered FCF (CA$, Millions) CA$1.99b CA$2.26b CA$2.44b CA$2.52b CA$2.63b CA$2.71b CA$2.78b CA$2.85b CA$2.91b CA$2.96b
Growth Rate Estimate Source Analyst x8 Analyst x6 Analyst x3 Analyst x2 Analyst x2 Est @ 3.16% Est @ 2.67% Est @ 2.33% Est @ 2.09% Est @ 1.93%
Present Value (CA$, Millions) Discounted @ 9.6% CA$1.8k CA$1.9k CA$1.9k CA$1.7k CA$1.7k CA$1.6k CA$1.5k CA$1.4k CA$1.3k CA$1.2k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$16b

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 (1.5%) 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 9.6%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = CA$3.0b× (1 + 1.5%) ÷ (9.6%– 1.5%) = CA$37b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$37b÷ ( 1 + 9.6%)10= CA$15b

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$31b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of CA$35.2, the company appears quite undervalued at a 37% 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.

dcf
TSX:PPL Discounted Cash Flow February 14th 2021

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 Pembina Pipeline 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 9.6%, which is based on a levered beta of 1.541. 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.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. 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 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 Pembina Pipeline, we've compiled three pertinent items you should consider:

  1. Risks: Every company has them, and we've spotted 3 warning signs for Pembina Pipeline (of which 1 makes us a bit uncomfortable!) you should know about.
  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for PPL'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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