fbpx
Trading

Is Essential Energy Services Ltd. (TSE: ESN) Trading At A 35% Discount?

Today we will run through one way of estimating the intrinsic value of Essential Energy Services Ltd. (TSE: ESN) by estimating the company’s future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. There’s really not all that much to it, even though it might appear quite complex.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for Essential 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 a 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.

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) forecast

2022

2023

2024

2025

2026

2027

2028

2029

2030

2031

Levered FCF (CA $, Millions)

CA $ 6.00m

CA $ 9.00m

CA $ 8.33m

CA $ 7.93m

CA $ 7.70m

CA $ 7.58m

CA $ 7.54m

CA $ 7.54m

CA $ 7.58m

CA $ 7.64m

Growth Rate Estimate Source

Analyst x1

Analyst x1

Est @ -7.48%

Est @ -4.77%

Est @ -2.87%

Est @ -1.54%

Est @ -0.61%

Est @ 0.04%

Est @ 0.5%

Est @ 0.82%

Present Value (CA $, Millions) Discounted @ 8.4%

CA $ 5.5

CA $ 7.7

CA $ 6.5

CA $ 5.7

CA $ 5.1

CA $ 4.7

CA $ 4.3

CA $ 4.0

CA $ 3.7

CA $ 3.4

(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA $ 50m

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. 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 an equity cost of 8.4%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = CA $ 7.6m × (1 + 1.6%) ÷ (8.4% – 1.6%) = CA $ 113m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA $ 113m ÷ (1 + 8.4%)10= CA $ 51m

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 $ 101m. To get the intrinsic value per share, we divide this by the total number of outstanding shares. Relative to the current share price of CA $ 0.5, the company appears quite undervalued at a 35% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope – move a few degrees and end up in a different galaxy. Do keep this in mind.

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 Essential 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 8.4%, which is based on a levered beta of 1,613. 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.

Moving On:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Preferably you’d apply different cases and assumptions and see how they would impact the company’s valuation. 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 Essential Energy Services, we’ve compiled three fundamental elements you should consider:

  1. Risks: As an example, we’ve found 1 warning sign for Essential Energy Services that you need to consider before investing here.

  2. Future Earnings: How does ESN’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: 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 into account 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.

Related Articles

Leave a Reply

Your email address will not be published.

Back to top button
KQ Education Group