Is There An Opportunity With Parkland Fuel Corporation's (TSE:PKI) 42% Undervaluation?

How far off is Parkland Fuel Corporation (TSE:PKI) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by estimating the company's future cash flows and discounting them to their present value. I will use the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for Parkland Fuel

Is Parkland Fuel fairly valued?

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 are 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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2019	2020	2021	2022	2023	2024	2025	2026	2027	2028
Levered FCF (CA$, Millions)	CA$242	CA$425	CA$540	CA$644	CA$735	CA$813	CA$877	CA$931	CA$976	CA$1.0k
Growth Rate Estimate Source	Analyst x1	Analyst x3	Est @ 26.85%	Est @ 19.38%	Est @ 14.15%	Est @ 10.49%	Est @ 7.93%	Est @ 6.13%	Est @ 4.88%	Est @ 4%
Present Value (CA$, Millions) Discounted @ 9.19%	CA$221	CA$357	CA$414	CA$453	CA$474	CA$479	CA$474	CA$460	CA$442	CA$421

Present Value of 10-year Cash Flow (PVCF)= CA$4.20b

"Est" = FCF growth rate estimated by Simply Wall St

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 10-year government bond rate of 1.9%. We discount the terminal cash flows to today's value at a cost of equity of 9.2%.

Terminal Value (TV) = FCF₂₀₂₉ × (1 + g) ÷ (r – g) = CA$1.0b × (1 + 1.9%) ÷ (9.2% – 1.9%) = CA$14b

Present Value of Terminal Value (PVTV) = TV / (1 + r)¹⁰ = CA$CA$14b ÷ ( 1 + 9.2%)¹⁰ = CA$5.93b

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$10.12b. In the final step we divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate of CA$69.31. Relative to the current share price of CA$40.25, the company appears quite undervalued at a 42% discount to what it is available for right now. DCFs are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

TSX:PKI Intrinsic value, April 16th 2019

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. 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 Parkland Fuel 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 9.2%, which is based on a levered beta of 1.216. 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 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?" 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. What is the reason for the share price to differ from the intrinsic value? For Parkland Fuel, There are three essential factors you should look at:

1. Financial Health: Does PKI have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.

2. Future Earnings: How does PKI'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 High Quality Alternatives: Are there other high quality stocks you could be holding instead of PKI? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. Simply Wall St updates its DCF calculation for every CA stock every day, so if you want to find the intrinsic value of any other stock just search here.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.