CES Energy Solutions Corp. (TSE:CEU) Shares Could Be 37% Below Their Intrinsic Value Estimate

editorial-team@simplywallst.com (Simply Wall St)
6-min read
In this article:

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, CES Energy Solutions fair value estimate is CA$11.79

  • Current share price of CA$7.48 suggests CES Energy Solutions is potentially 37% undervalued

  • The CA$8.75 analyst price target for CEU is 26% less than our estimate of fair value

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of CES Energy Solutions Corp. (TSE:CEU) 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. It may sound complicated, but actually it is quite simple!

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. 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 CES Energy Solutions

The Model

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

2025

2026

2027

2028

2029

2030

2031

2032

2033

2034

Levered FCF (CA$, Millions)

CA$184.6m

CA$197.5m

CA$188.0m

CA$196.0m

CA$199.0m

CA$202.3m

CA$206.0m

CA$209.9m

CA$214.0m

CA$218.2m

Growth Rate Estimate Source

Analyst x5

Analyst x2

Analyst x1

Analyst x1

Est @ 1.52%

Est @ 1.69%

Est @ 1.81%

Est @ 1.89%

Est @ 1.95%

Est @ 1.99%

Present Value (CA$, Millions) Discounted @ 8.7%

CA$170

CA$167

CA$146

CA$141

CA$131

CA$123

CA$115

CA$108

CA$101

CA$95.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$1.3b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 8.7%.

Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = CA$218m× (1 + 2.1%) ÷ (8.7%– 2.1%) = CA$3.4b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$3.4b÷ ( 1 + 8.7%)10= CA$1.5b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is CA$2.8b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of CA$7.5, the company appears quite good value at a 37% 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
dcf

Important 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 CES Energy Solutions 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 8.7%, which is based on a levered beta of 1.433. 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 CES Energy Solutions

Strength

  • Earnings growth over the past year exceeded the industry.

  • Debt is well covered by earnings and cashflows.

  • Dividends are covered by earnings and cash flows.

Weakness

  • Dividend is low compared to the top 25% of dividend payers in the Energy Services market.

Opportunity

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

  • Trading below our estimate of fair value by more than 20%.

Threat

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

Looking Ahead:

Whilst important, the DCF calculation 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. 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. 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. What is the reason for the share price sitting below the intrinsic value? For CES Energy Solutions, there are three further items you should assess:

  1. Risks: Be aware that CES Energy Solutions is showing 2 warning signs in our investment analysis , you should know about...

  2. Future Earnings: How does CEU'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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com