Is Birchcliff Energy Ltd. (TSE:BIR) Trading At A 44% Discount?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Birchcliff Energy fair value estimate is CA$13.71

• Birchcliff Energy is estimated to be 44% undervalued based on current share price of CA$7.70

• The CA$11.30 analyst price target for BIR is 18% less than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of Birchcliff Energy Ltd. (TSE:BIR) by taking the expected future cash flows and discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

View our latest analysis for Birchcliff Energy

Step By Step Through The Calculation

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. 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, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (CA$, Millions)	CA$248.3m	CA$316.7m	CA$240.0m	CA$310.0m	CA$280.0m	CA$278.7m	CA$279.3m	CA$281.2m	CA$284.1m	CA$287.5m
Growth Rate Estimate Source	Analyst x9	Analyst x9	Analyst x1	Analyst x1	Analyst x1	Est @ -0.45%	Est @ 0.21%	Est @ 0.68%	Est @ 1.00%	Est @ 1.23%
Present Value (CA$, Millions) Discounted @ 8.7%	CA$228	CA$268	CA$187	CA$222	CA$185	CA$169	CA$156	CA$144	CA$134	CA$125

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$1.8b

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 1.8%. We discount the terminal cash flows to today's value at a cost of equity of 8.7%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = CA$288m× (1 + 1.8%) ÷ (8.7%– 1.8%) = CA$4.2b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$4.2b÷ ( 1 + 8.7%)¹⁰= CA$1.8b

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$3.7b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of CA$7.7, the company appears quite good value at a 44% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf

Important Assumptions

We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Birchcliff 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 8.7%, which is based on a levered beta of 1.165. 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 Birchcliff Energy

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is not viewed as a risk.

• Dividends are covered by earnings and cash flows.

• Dividend is in the top 25% of dividend payers in the market.

Weakness

• No major weaknesses identified for BIR.

Opportunity

• Trading below our estimate of fair value by more than 20%.

• Significant insider buying over the past 3 months.

Threat

• Annual revenue is expected to decline over the next 2 years.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and 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. 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. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. Can we work out why the company is trading at a discount to intrinsic value? For Birchcliff Energy, we've put together three additional factors you should consider:

1. Risks: Take risks, for example - Birchcliff Energy has 1 warning sign we think you should be aware of.

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for BIR's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

3. Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.

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