Key Insights

The projected fair value for Surge Energy is CA$15.99 based on 2 Stage Free Cash Flow to Equity Surge Energy is estimated to be 49% undervalued based on current share price of CA$8.10 Analyst price target for SGY is CA$13.15 which is 18% below our fair value estimate

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Surge Energy Inc. (TSE:SGY) as an investment opportunity by taking the expected future cash flows and discounting them to today's 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.

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. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

See our latest analysis for Surge Energy

Is Surge Energy Fairly Valued?

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. 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$92.6m CA$111.7m CA$127.0m CA$133.4m CA$138.8m CA$143.5m CA$147.7m CA$151.5m CA$155.1m CA$158.5m Growth Rate Estimate Source Analyst x6 Analyst x6 Analyst x2 Est @ 5.05% Est @ 4.07% Est @ 3.39% Est @ 2.91% Est @ 2.58% Est @ 2.35% Est @ 2.18% Present Value (CA$, Millions) Discounted @ 10.0%  CA$84.2 CA$92.4 CA$95.5 CA$91.3 CA$86.4 CA$81.2 CA$76.0 CA$70.9 CA$66.0 CA$61.4

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$806m

The second stage is also known as Terminal Value, this is the business's cash flow after 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 (1.8%) 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 a cost of equity of 10.0%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = CA$158m× (1 + 1.8%) ÷ (10.0%– 1.8%) = CA$2.0b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$2.0b÷ ( 1 + 10.0%)10= CA$766m

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$1.6b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of CA$8.1, the company appears quite good value at a 49% 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

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. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Surge 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 1.372. 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 Surge Energy

Strength

Debt is not viewed as a risk.

Dividends are covered by earnings and cash flows.

Weakness

Earnings declined over the past year.

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

Shareholders have been diluted in the past year.

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:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for 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?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price sitting below the intrinsic value? For Surge Energy, we've put together three important factors you should further examine:

Risks: We feel that you should assess the 4 warning signs for Surge Energy (1 makes us a bit uncomfortable!) we've flagged before making an investment in the company. Future Earnings: How does SGY'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. 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. 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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