Calculating The Fair Value Of Source Energy Services Ltd. (TSE:SHLE)

Does the May share price for Source Energy Services Ltd. (TSE:SHLE) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the forecast future cash flows of the company and discounting them back to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. 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.

Check out our latest analysis for Source Energy Services

Step by step through the calculation

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. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (CA$, Millions)	CA$7.33m	CA$5.24m	CA$4.22m	CA$3.66m	CA$3.34m	CA$3.15m	CA$3.04m	CA$2.98m	CA$2.95m	CA$2.95m
Growth Rate Estimate Source	Est @ -41.42%	Est @ -28.53%	Est @ -19.5%	Est @ -13.18%	Est @ -8.76%	Est @ -5.66%	Est @ -3.5%	Est @ -1.98%	Est @ -0.92%	Est @ -0.17%
Present Value (CA$, Millions) Discounted @ 10%	CA$6.7	CA$4.3	CA$3.2	CA$2.5	CA$2.1	CA$1.8	CA$1.6	CA$1.4	CA$1.2	CA$1.1

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$25m

The second stage is also known as Terminal Value, this is the business's cash flow after 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 10%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = CA$2.9m× (1 + 1.6%) ÷ (10%– 1.6%) = CA$35m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$35m÷ ( 1 + 10%)¹⁰= CA$14m

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$39m. 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$2.3, the company appears about fair value at a 18% 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 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 Source Energy Services 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 2.000. 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.

Looking Ahead:

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. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Source Energy Services, there are three additional aspects you should further research:

1. Risks: For example, we've discovered 3 warning signs for Source Energy Services (1 can't be ignored!) that you should be aware of before investing here.
2. Future Earnings: How does SHLE'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.