MEG Energy shares are likely to trade at ~$35 to $40 a share within three years

Unless commodity prices tank, of course

MEG Energy (MEG.TO) is a worthwhile company to review in the context of today’s energy markets. I approach investments in energy by comparing trading prices to my own take on the underlying value of the company in question.

Corporate valuation is often as much an art as a science. Sell-side analysts and brokerage firms love to use multiples of EBITDA and at least one fund manager likes to value the stock of a company in relation to how long it would take to “go private” at the current share price (as if all investors would sell at that price, an unlikely occurrence) with a gleeful claim that all free cash flows after that point in time are “free” if shares are purchased at the current price. He then applies a multiple of free cash flow and concludes on the “upside” he sees in the shares.

These approaches are intended to prompt trading in the case of the sell-side, since sell-side intermediary fees are based in part on trading commissions, and to prompt unsophisticated investors to buy units of the Fund being promoted by the fund manager in his case. Oddly, if the Fund manager is correct, you don’t need to buy into his Fund, just buy the stock if he says it can go private in a few years and have decades of future cash flows for “free”.

I am old, and old-school so I rely both on well-established valuation models and on more modern ones. The oldest (and in some cases the most reliable) valuation model is the dividend discount model but it is useless when the company in question chooses not to pay a dividend (of course you can still apply the Gordon dividend model by assuming the company pays out free cash flow as a dividend) or when the rate of growth in future dividends exceeds the required rate of return in the Gordon model. The Gordon model offers simplicity but implies a steady rate of growth in dividends in perpetuity. Perpetuity is a bit too long for sensible consideration but the model gets widespread use since the assumption of perpetual growth is immaterial if growth the assumed rate persists for fifteen or twenty years.

In the case of MEG, annual free cash flows of $1.2 billion ($4.00 a share) seem within reach based on a sustaining capital assumption of $300 million per year and an oil price of ~$80 Canadian (albeit with some volatility as commodity prices fluctuate). At a 12% required rate of return and steady production (i.e., zero growth in free cash flows which I will assume are paid out in dividends) the Gordon model values MEG shares at $4.00/.12 = ~$33.00. That is not far from 8 x FCF which I often see used by analysts as a valuation metric. Multiples of cash flow and the Gordon model both imply no change in operating cash flows over time.

A more modern approach to valuation of resource companies is to use a modified Black-Scholes valuation treating the company’s resource as a “real option” on future commodity prices. This approach has growing application in oil & gas companies, with valuation firm Mercer promoting its use for valuation of proven but undeveloped oil reserves. With 951 million barrels of oil reserves according to the latest reserve report and production of about 100,000 boe/day (36.5 million barrels a year) MEG has at least 27 years of production from existing reserves. Assuming a required rate of return of 12% after taxes, a combined royalty and tax rate of 20% and a 27 year reserve life, Black Scholes returns a value for MEG shares of CAD$39.19 per share.

The benefit of Black Scholes as a valuation model is that it explicitly takes volatility of oil prices into account, something absent from Discounted Cash Flow valuation, the Gordon model, or reliance on multiples of current cash flows. Commodity prices, while not known in future periods, are known to be log-normally distributed and Black Scholes makes that assumption. Like most valuation approaches, there is no assurance the value returned will be realized or that actual outcomes will approximate the valuation estimates. Nonetheless, it is a reasonable guide for assessing value and is consistent with the conclusion that MEG shares remain undervalued.

Often, the market discounts factors not included in financial models including decisions taken by management - changes to hedging practices for example. I discount MEG shares owing to my lack of confidence in Derek Evans as CEO. Notwithstanding, I believe MEG shares are probably undervalued by the market today.