An Intrinsic Calculation For Strathcona Resources Ltd. (TSE:SCR) Suggests It's 22% Undervalued

Key Insights

• Strathcona Resources' estimated fair value is CA$40.20 based on 2 Stage Free Cash Flow to Equity

• Strathcona Resources' CA$31.19 share price signals that it might be 22% undervalued

• The CA$35.38 analyst price target for SCR is 12% less than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of Strathcona Resources Ltd. (TSE:SCR) 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. There's really not all that much to it, even though it might appear quite complex.

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.

View our latest analysis for Strathcona Resources

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 higher growth, and the second stage is a lower growth phase. 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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CA$, Millions)	CA$761.3m	CA$691.7m	CA$616.0m	CA$600.3m	CA$593.4m	CA$592.3m	CA$595.2m	CA$601.0m	CA$608.8m	CA$618.2m
Growth Rate Estimate Source	Analyst x3	Analyst x3	Analyst x1	Est @ -2.54%	Est @ -1.16%	Est @ -0.19%	Est @ 0.49%	Est @ 0.97%	Est @ 1.30%	Est @ 1.54%
Present Value (CA$, Millions) Discounted @ 8.4%	CA$702	CA$588	CA$483	CA$434	CA$396	CA$364	CA$338	CA$315	CA$294	CA$275

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$4.2b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (2.1%) 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 8.4%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CA$618m× (1 + 2.1%) ÷ (8.4%– 2.1%) = CA$9.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CA$9.9b÷ ( 1 + 8.4%)¹⁰= CA$4.4b

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$8.6b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of CA$31.2, the company appears a touch undervalued at a 22% 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

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. 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 Strathcona Resources 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 1.381. 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 Strathcona Resources

Strength

• Debt is well covered by earnings and cashflows.

Weakness

• Earnings declined over the past year.

Opportunity

• Annual earnings are forecast to grow faster than the Canadian market.

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

• Significant insider buying over the past 3 months.

Threat

• Annual revenue is expected to decline over the next 2 years.

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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 Strathcona Resources, there are three fundamental items you should look at:

1. Risks: Take risks, for example - Strathcona Resources has 2 warning signs we think you should be aware of.

2. Future Earnings: How does SCR'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.

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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.