Energy resources are the essential part of human society, as all economic activity requires energy resources, whether to manufacture goods, provide transportation or to run computers. The Oil & Gas Midstream sector is capital intensive and comprised of long term contracts, With the Shale boom and a potential of increase in demand for fossil fuel due to revival of economic activity, the outlook of this sector seems quite attractive. To further analyze, which stock in the Energy sector is providing investors with the highest return potentials, I have selected four main industrial players to conduct comparative analysis, which include Kinder Morgan Inc. (NYSE:KMI), Enterprise Product Partners (NYSE:EPD), Enbridge Inc. (NYSE:ENB) and TransCanada Corporation (NYSE:TRP). First of all I have used Comparable Approach to screen out undervalued stocks, after that DCF is carried out to determine intrinsic value of stocks screened out earlier. The rationale for using the Discounted Cash Flow method is that it is widely used and is the preferred method as it incorporates Future Cash Flow stream rather than just one year view.
The simplest way to evaluate whether a stock is overvalued or undervalued is by estimating the value of the company and then comparing it to its competitors. In order to calculate the equity value per share, I have first calculated the average multiples of the selected companies by using key valuation measures including Price-to-Earnings ratio, Price-to-Book value, Price-to-Sales ratio, Price-to-Cash flow, Enterprise Value-to-EBITDA and Enterprise-Value to Revenue, as shown in table below:
Valuation Based on Peer Comparison with Energy Sector
Company Financials, Reuters, CapIQ | UNITS | KMI | EPD | ENB | TRP | Average Multiples |
P/E TTM | X | 107.69 | 21.31 | 56.19 | 26.60 | 52.95 |
P/BV (mrq) | X | 2.80 | 4.00 | 5.50 | 2.20 | 3.63 |
P/S TTM | X | 5.10 | 1.20 | 1.40 | 4.20 | 2.98 |
Price/Cash Flow | X | 18.10 | 17.90 | 12.60 | 9.70 | 14.58 |
EV/EBITDA | X | 16.71 | 16.15 | 22.19 | 13.82 | 17.22 |
EV/Revenue | X | 7.26 | 1.60 | 2.23 | 6.81 | 4.48 |
For calculating equity value, I used normalized earnings and cash flows instead of using reported numbers in order to include true picture of company's earnings and cash flows, as reported numbers can be misleading due to nonrecurring items.
Valuation Using [TTM] Normalized Earnings & Cash Flows | AVG Multiples | KMI | EPD | ENB | TRP |
P/E TTM | 52.95 | 0.35 | 2.71 | 0.80 | 1.88 |
P/BV (mrq) | 3.63 | 13.39 | 14.74 | 8.60 | 22.66 |
P/S TTM | 2.98 | 11.00 | 49.41 | 33.41 | 11.58 |
Price/Cash Flow | 14.58 | 3.09 | 3.36 | 3.80 | 5.11 |
EV/EBITDA | 17.22 | 1.54 | 4.89 | 3.37 | 5.70 |
EV/Revenue | 4.48 | 11.00 | 49.41 | 33.41 | 11.58 |
Further, I have calculated equity value per share of subject companies by using average multiples. To further smooth down, valuation weights are assigned to multiples based on judgment and reliability of multiples as shown in the following table. I have assigned 30 percent weight to both P/CF and EV/EBITDA. My reasons for assigning higher weight to these are that both are more reliable valuation multiples and are widely used in the investment community for the purpose of stock valuation.
Equity Value Per Share | UNITS | KMI | EPD | ENB | TRP | Weights |
P/E TTM | USD | 18.53 | 143.49 | 42.36 | 99.54 | 10% |
P/BV (mrq) | USD | 48.54 | 53.43 | 31.18 | 82.14 | 10% |
P/S TTM | USD | 32.73 | 146.99 | 99.39 | 34.45 | 10% |
Price/Cash Flow | USD | 45.03 | 48.97 | 55.34 | 74.46 | 30% |
EV/EBITDA | USD | 27.14 | 84.31 | 60.28 | 99.02 | 30% |
EV/Revenue | USD | 49.93 | 221.15 | 151.78 | 52.62 | 10% |
Estimated Equity Value | USD | 36.6 | 96.5 | 67.2 | 78.9 | |
Upside / Downside | % | -0.92% | 68.53% | 46.53% | 61.8% | |
Current Stock Valuation | Over Valued | Under Valued | Under Valued | Under Valued | ||
Current Price | USD | 36.94 | 57.26 | 45.95 | 48.741 |
The table given above shows the estimated equity value derived by weighted average multiple valuation approach and then comparing it with current market price. This analysis clearly depicts that EPD and TRP are offering higher upside potential to investors while KMI is overvalued. By utilizing comparable valuation approach, we have been able screen out two companies, EPD and TRP, based on their upside potential, which is 68.53 percent and 61.8 percent respectively as show in table above.
For further scrutiny of the shortlisted companies and to determine which of these is offering the highest return to shareholders, a comparative analysis of EPD and TRP with industry is carried out. I have made use of their financial ratios and compared those with the industry averages, to have a better idea of each company's performance relative to the industry.
Company Financials, Reuters, CapIQ,Morning Star | UNITS | EPD | TRP | Industry Average |
Cash / Share | USD | 0.04 | 0.80 | N/A |
Dividend Yield | % | 4.5% | 3.7% | 4.6% |
Rev Growth (3 YrAvg) | % | 18.6% | 0.3% | 7.1% |
EPS Growth (3 YrAvg) | % | 39.9% | -4.5% | N/A |
Forward P/E Analyst Estimates | X | 20.0 | 19.9 | N/A |
Operating Margin TTM | % | 7% | 34% | 11% |
Net Margin TTM | % | 11.4% | 15.7% | 5.2% |
ROE TTM | % | 38.3% | 8.2% | 11.9% |
Debt/Equity | X | 1.10 | 1.20 | 1.4 |
EPD's ROE stands at a level of 39.9 percent, which is higher than that of TRP and the industry average. Analysis of dividend yield, revenue growth, EPS growth and ROE favors EPD as its values are well above the industry average and TRP ratios, except dividend yield, which is less than the industry average. But if we look at the 5 year averages of dividend yields of EDP and TRP than the picture becomes quite clear. EPD has 5 year average dividend yield of 6.5 percent as compared to TRP's 4.10 percent. This clearly favors EPD over TRP.
Dividend Yield 5 year Average | % |
TRP | 4.10% |
EPD | 6.50% |
I have further analyzed both companies' historical margins and calculated 5 year average in order to separate the best among the two selected companies.
2008 | 2009 | 2010 | 2011 | 2012 | 5 Year Average | |
| 33.1% | 30.8% | 30.2% | 35.2% | 34.2% | 32.7% |
EPD | 6.5% | 7.1% | 6.4% | 6.5% | 7.2% | 6.7% |
NPM [%] | ||||||
TRP | 16.7% | 15.3% | 15.2% | 16.7% | 15.7% | 15.9% |
EPD | 4.4% | 4.0% | 1.0% | 4.6% | 11.4% | 5.1% |
ROE [%] | ||||||
TRP | 12.7% | 9.8% | 8.0% | 9.7% | 8.2% | 9.7% |
EPD | 15.6% | 13.2% | 3.1% | 17.4% | 38.3% | 17.5% |
D/E [x] | ||||||
TRP | 1.35 | 1.18 | 1.21 | 1.21 | 1.21 | 1.2 |
EPD | 1.5 | 1.19 | 1.17 | 1.16 | 1.11 | 1.2 |
FCF | ||||||
TRP [CAD] | -0.42 | -3.55 | -2.82 | 0.98 | 1.39 | -0.884 |
EPD [USD] | -1.71 | 1.62 | 0.93 | -0.7 | -0.82 | -0.136 |
Capex [% of Sales] | ||||||
TRP | 36.4 | 60.4 | 62.5 | 35.8 | 31.4 | 45.29 |
EPD | 9.1 | 6.2 | 6.1 | 8.7 | 8.5 | 7.71 |
Instead of a single year analysis, a comparison of profitability based on 5 years averages is presented below, ROE of EPD stands at 17.5 percent as compared to 9.7 percent of TRP, EPD dividend yield is 6.5 percent as compared to 4.1percent of TRP, 5 year average FCF of EPD is higher than that of TRP. EPD Free Cash Flows remained depressed in past few years due to investment in expansionary projects which have not started generating economic benefit as yet. When the new projects start generating cash flow, then negative FCF will turn positive and it is likely to be the case in the near future. 5 year average analysis clearly supports EPD as it dominates TRP in Dividend Yield, Revenue Growth, EPS Growth, Forward P/E and ROE.
Valuation using DCF Method
EPD operates in a capital intensive industry and current company free cash flow is negative due to reinvestment; therefore the most appropriate approach to value it is DCF.
The stock has been valued using Discounted Cash Flow (DCF) model. DCF method is preferred because it incorporates future cash flows. I have used risk free rate of 1.8 percent, beta of 0.9 (industry average re levered) and equity risk premium of 6 percent leading to a cost of equity of 7.25 percent and WACC of 6.46 percent in this model. The projections for next 5 years have been made. The assumptions include two distinct growth periods: (1) high growth period, and (2) relatively stable growth period and a long term growth rate of 2 percent.
Free cash flow buildup | 2013 | 2014 | 2015 | 2016 | 2017 |
Revenues | 46,841 | 53,867 | 64,641 | 71,105 | 76,794 |
Cash Flow From Operations | 3,274 | 3,873 | 4,776 | 5,396 | 5,982 |
Capital Expenditures | (2,400) | (4,800) | (3,000) | (2,500) | (2,000) |
Unlevered free cash flows | 874 | (927) | 1,776 | 2,896 | 3,982 |
Discount Factor | 1.0 | 0.9 | 0.8 | 0.8 | 0.7 |
Midyear adjustment factor | 1.03 | 1.03 | 1.03 | 1.03 | 1.03 |
Present value of free cash flows | 852 | (854) | 1,537 | 2,354 | 3,040 |
Sum of present values of FCFs | 6,929 |
Terminal value | Equity value calculations | ||||
Growth in perpetuity method | Enterprise value | 76,430 | |||
Long term growth rate | 2.0% | Debt | (14,529) | ||
Free cash flow (t+1) | 4,061 | Cash & Investments | 65.5 | ||
Terminal value | 91,022 | ||||
Midyear adjusted terminal value | 93,917 | Equity value | 61,966.91 | ||
Present value of terminal value | 69,501 | Shares outstanding | 908.81 | ||
Enterprise value | 76,430 | Equity value / share | 68.18 |
To calculate enterprise value, perpetual growth method is used with the assumption of a 2 percent long term growth rate. The terminal value is calculated using 2017 unlevered free cash flow and then by applying discount factor and midyear adjustment factors, the present value equals 69.50billion, enterprise value equals USD 76.430 billion by adding present value of FCFs and present value of terminal value.
Equity value is determined by subtracting EPD debt and adding cash & investments to enterprise value calculated using DCF method. By dividing the equity value of USD 61,967 million from its share outstanding of 909 million, we arrive at an equity value of USD 68.18 per share.
Discount Rate Assumptions
Discount factor is calculated using weighted average cost of capital and sub year fraction. Sub year fraction is used to adjust the fiscal year till the date of evaluation. The calculation of WACC is shown in the table below:
Cost of debt | Capital Structure | ||||||
Cost of debt | 4.50% | Current capital structure | Target capital structure | ||||
Marginal tax rate | 20.00% | Market value | % Weights | Override | % Weight | ||
Cost of debt after tax shield | 3.60% | debt | 14,529 | 21.60% | 21.60% | ||
Equity | 52,745 | 78.40% | 78.40% | ||||
Cost of equity | Total | 67,274 | |||||
Risk-free rate (rf) | 1.85% | ||||||
Market Risk Premium (rm - rf) | 6.00% | Weight average cost of capital | |||||
Re Levered Industry average Beta | 0.90 | Weight average cost of capital | 6.46% | ||||
7.25% |
It is important to note that cash flows of a company are distributed throughout the year. But DCF method discounts the cash flows on the assumption that cash flows in a given year are calculated at the end of the year. In order to measure the discounted cash flows more accurately we need to discount the cash flows mid-year, and for that mid-year adjustment factor is used to discount unlevered free cash flows using discount factor and mid-year adjustment factor as shown in the table.
In the end, I have assigned 70 percent weight to equity value DCF method and 30 percent weight to Multiples Valuation method, based upon personal judgment. This combination of these two valuation methods results into a fair value of EPD of 76.68 per share. Currently the stock is trading at USD 57.67 per share which makes it clear that EPD stock is currently undervalued. Buy EPD with a target price USD 76.68 (31 Dec 20013)
Equity Value DCF Method | 68.18 | 70.0% |
Equity Value Multiples Method | 96.49 | 30.0% |
Fair Value | 76.68 |
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.