Imperial Oil Limited's (TSE:IMO) Intrinsic Value Is Potentially 31% Above Its Share Price

Key Insights

• Imperial Oil's estimated fair value is CA$88.81 based on 2 Stage Free Cash Flow to Equity

• Current share price of CA$67.57 suggests Imperial Oil is potentially 24% undervalued

• Our fair value estimate is 13% lower than Imperial Oil's analyst price target of CA$77.67

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Imperial Oil Limited (TSE:IMO) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

View our latest analysis for Imperial Oil

Crunching The Numbers

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.

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) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (CA$, Millions)	CA$5.55b	CA$6.00b	CA$3.67b	CA$3.88b	CA$3.83b	CA$3.82b	CA$3.84b	CA$3.87b	CA$3.91b	CA$3.96b
Growth Rate Estimate Source	Analyst x7	Analyst x6	Analyst x2	Analyst x1	Analyst x1	Est @ -0.21%	Est @ 0.38%	Est @ 0.80%	Est @ 1.09%	Est @ 1.29%
Present Value (CA$, Millions) Discounted @ 8.9%	CA$5.1k	CA$5.1k	CA$2.8k	CA$2.8k	CA$2.5k	CA$2.3k	CA$2.1k	CA$1.9k	CA$1.8k	CA$1.7k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$28b

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 (1.8%) 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 8.9%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = CA$4.0b× (1 + 1.8%) ÷ (8.9%– 1.8%) = CA$56b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$56b÷ ( 1 + 8.9%)¹⁰= CA$24b

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$52b. 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$67.6, the company appears a touch undervalued at a 24% 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

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 Imperial Oil 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 8.9%, which is based on a levered beta of 1.210. 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 Imperial Oil

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is not viewed as a risk.

• Dividends are covered by earnings and cash flows.

Weakness

• 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:

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. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Imperial Oil, there are three relevant aspects you should assess:

1. Risks: To that end, you should be aware of the 1 warning sign we've spotted with Imperial Oil .

2. Future Earnings: How does IMO'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. 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.

Join A Paid User Research Session
You’ll receive a US$30 Amazon Gift card for 1 hour of your time while helping us build better investing tools for the individual investors like yourself. Sign up here