Vermilion Energy Inc.'s (TSE:VET) Intrinsic Value Is Potentially 76% Above Its Share Price

Key Insights

• Vermilion Energy's estimated fair value is CA$31.66 based on 2 Stage Free Cash Flow to Equity

• Current share price of CA$17.97 suggests Vermilion Energy is potentially 43% undervalued

• Analyst price target for VET is CA$29.11 which is 8.1% below our fair value estimate

How far off is Vermilion Energy Inc. (TSE:VET) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by projecting its future cash flows and then discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

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. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

See our latest analysis for Vermilion Energy

The Calculation

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. 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 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$776.6m	CA$1.03b	CA$611.3m	CA$611.0m	CA$480.0m	CA$408.3m	CA$367.7m	CA$344.1m	CA$330.4m	CA$323.0m
Growth Rate Estimate Source	Analyst x8	Analyst x8	Analyst x3	Analyst x2	Analyst x1	Est @ -14.95%	Est @ -9.93%	Est @ -6.43%	Est @ -3.97%	Est @ -2.25%
Present Value (CA$, Millions) Discounted @ 10.0%	CA$706	CA$851	CA$460	CA$418	CA$299	CA$231	CA$189	CA$161	CA$141	CA$125

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$3.6b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 10.0%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = CA$323m× (1 + 1.8%) ÷ (10.0%– 1.8%) = CA$4.0b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$4.0b÷ ( 1 + 10.0%)¹⁰= CA$1.6b

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$5.1b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of CA$18.0, the company appears quite good value at a 43% 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

The Assumptions

Now 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 Vermilion 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 10.0%, which is based on a levered beta of 1.380. 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 Vermilion Energy

Strength

• Debt is not viewed as a risk.

• Dividends are covered by earnings and cash flows.

Weakness

• Earnings growth over the past year underperformed the Oil and Gas industry.

• Dividend is low compared to the top 25% of dividend payers in the Oil and Gas market.

Opportunity

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

Threat

• Annual earnings are forecast to decline for the next 3 years.

Looking Ahead:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching 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 example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Vermilion Energy, we've compiled three pertinent elements you should further research:

1. Risks: For instance, we've identified 4 warning signs for Vermilion Energy (1 is a bit concerning) you should be aware of.

2. Future Earnings: How does VET'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.

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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