Are Investors Undervaluing Arrow Exploration Corp. (CVE:AXL) By 49%?

Key Insights

• Arrow Exploration's estimated fair value is CA$1.00 based on 2 Stage Free Cash Flow to Equity

• Arrow Exploration's CA$0.51 share price signals that it might be 49% undervalued

• Industry average discount to fair value of 37% suggests Arrow Exploration's peers are currently trading at a lower discount

In this article we are going to estimate the intrinsic value of Arrow Exploration Corp. (CVE:AXL) by taking the forecast future cash flows of the company and discounting them back to today's value. This will be done using the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

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

View our latest analysis for Arrow Exploration

The Calculation

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 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

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF ($, Millions)	US$45.3m	US$29.2m	US$24.0m	US$15.0m	US$11.6m	US$9.76m	US$8.76m	US$8.18m	US$7.86m	US$7.69m
Growth Rate Estimate Source	Analyst x3	Analyst x2	Analyst x1	Analyst x1	Est @ -23.07%	Est @ -15.52%	Est @ -10.24%	Est @ -6.55%	Est @ -3.96%	Est @ -2.15%
Present Value ($, Millions) Discounted @ 7.1%	US$42.3	US$25.4	US$19.6	US$11.4	US$8.2	US$6.5	US$5.4	US$4.7	US$4.2	US$3.9

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$132m

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. 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 7.1%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = US$7.7m× (1 + 2.1%) ÷ (7.1%– 2.1%) = US$157m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$157m÷ ( 1 + 7.1%)¹⁰= US$79m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$211m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of CA$0.5, the company appears quite undervalued 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

The Assumptions

Now 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 Arrow Exploration 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 7.1%, which is based on a levered beta of 1.089. 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 Arrow Exploration

Strength

• Currently debt free.

Weakness

• Shareholders have been diluted in the past year.

Opportunity

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

Threat

• No apparent threats visible for AXL.

Next Steps:

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. 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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Why is the intrinsic value higher than the current share price? For Arrow Exploration, we've put together three pertinent elements you should further research:

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

2. Future Earnings: How does AXL'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 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 TSXV 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.

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