MEG Energy Corp.'s (TSE:MEG) Intrinsic Value Is Potentially 75% Above Its Share Price

Key Insights

• MEG Energy's estimated fair value is CA$35.98 based on 2 Stage Free Cash Flow to Equity

• Current share price of CA$20.55 suggests MEG Energy is potentially 43% undervalued

• Our fair value estimate is 38% higher than MEG Energy's analyst price target of CA$26.12

In this article we are going to estimate the intrinsic value of MEG Energy Corp. (TSE:MEG) by taking the forecast future cash flows of the company and discounting them back to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. There's really not all that much to it, even though it might appear quite complex.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for MEG Energy

Crunching The Numbers

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 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (CA$, Millions)	CA$910.7m	CA$1.08b	CA$973.0m	CA$912.2m	CA$877.3m	CA$858.5m	CA$850.3m	CA$849.1m	CA$852.9m	CA$860.2m
Growth Rate Estimate Source	Analyst x6	Analyst x7	Analyst x1	Est @ -6.24%	Est @ -3.83%	Est @ -2.14%	Est @ -0.96%	Est @ -0.13%	Est @ 0.45%	Est @ 0.85%
Present Value (CA$, Millions) Discounted @ 9.5%	CA$832	CA$902	CA$741	CA$635	CA$558	CA$498	CA$451	CA$411	CA$377	CA$347

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$5.8b

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 1.8%. We discount the terminal cash flows to today's value at a cost of equity of 9.5%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = CA$860m× (1 + 1.8%) ÷ (9.5%– 1.8%) = CA$11b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$11b÷ ( 1 + 9.5%)¹⁰= CA$4.6b

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$10b. 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$20.6, the company appears quite good value at a 43% 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

The Assumptions

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 MEG 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 9.5%, which is based on a levered beta of 1.294. 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 MEG Energy

Strength

• Debt is not viewed as a risk.

Weakness

• Earnings declined over the past year.

Opportunity

• Annual earnings are forecast to grow faster than the Canadian market.

• Good value based on P/E ratio and estimated fair value.

Threat

• Annual revenue is expected to decline over the next 3 years.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. 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. Why is the intrinsic value higher than the current share price? For MEG Energy, we've compiled three fundamental factors you should explore:

1. Risks: For example, we've discovered 1 warning sign for MEG Energy that you should be aware of before investing here.

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for MEG'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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