By Cagdas Ozcan
Canadian Natural Resources (NYSE:CNQ) is one of the largest Canadian independent energy companies. The company is engaged in the acquisition, development, exploration and production of crude oil, natural gas, and natural gas liquids. CNQ stock has gained about 10% over the past three months. Judging from analysts' estimates about future earnings, the company is set to experience positive growth in 2013. As a result, we decided to apply our own fair value model to see how much potential there is in this stock. The results of our fair value model based on longterm earnings growth of the company are discussed below.
At the time this article was written, CNQ stock was trading at around $32.16, with a 52week range of $25.01 to $32.33. It has a market cap of about $35.2 billion. The trailing 12month P/E ratio of 15.2 is above the forward P/E ratio of 11.9. P/B, P/S, and P/CF ratios stand at 1.5, 2.1, and 5.2, respectively. The operating margin is 22.1%, while the net profit margin is 14.0%.
CNQ has a fivestar rating from Morningstar. Out of 10 analysts covering the stock, three have buy recommendations and two have hold recommendations. Most of the analysts have positive ratings, and only one analyst is neutral on the stock. The average fiveyear annualized growth forecast estimate is 8%.
We can estimate CNQ's fair value using discounted earnings plus equity model as follows.
Discounted Earnings Plus Equity Model
This model is primarily used for estimating the returns from longterm projects. It is also frequently used to price fairvalued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:
V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5+ Disposal Value
V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]
The earnings after the last period act as a perpetuity that creates regular earnings:
Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r
While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the currentperiod earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my estimates. You can set these parameters as you wish, according to your own diligence.
Valuation
Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate. In order to smooth the results, I will also take the average of TTM EPS along with the mean EPS estimate for the next year. The average EPS for CNQ is $1.99.
While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. The average fiveyear growth forecast is 8%. Book value per share is $22.13.
Fair Value Estimator  
V0 
E_{0} 
$1.99 
V1 
E_{0} (1+g)/(1+r) 
$1.94 
V2 
E_{0}((1+g)/(1+r))^{2} 
$1.88 
V3 
E_{0}((1+g)/(1+r))^{3} 
$1.83 
V4 
E_{0}((1+g)/(1+r))^{4} 
$1.78 
V5 
E_{0}((1+g)/(1+r))^{5} 
$1.74 
D 
E_{0}(1+g)^{5}/[r(1+r)^{5}] 
$15.77 
BV 
Equals 
$22.13 
Fair Value Range 
Lower Boundary 
$26.94 
Upper Boundary 
$49.07 

Potential 
52.57% 
(You can download the FED+ Fair Value Estimator here.)
I decided to add the book value per share so that we can distinguish between a lowdebt and debtloaded company. The lower boundary does not include the book value. According to my fiveyear discountedearningsplusbookvalue model, the fairvalue range for CNQ is between $26.94 and $49.07 per share. At a price of about $32, CNQ is close to the lower boundary of its fair value range. The stock still has up to 53% upside potential to reach its fair value maximum.
Summary
Click to enlarge.
Canadian Natural Resources has longterm strategy of shifting its focus toward oil projects. In the past, the company has been affected by low natural gas prices. A shift toward oil assets should provide the company with less volatility in the prices. As a result, we believe there is strong potential present in this stock.
According to our fair value model, CNQ should trade higher based on future growth potential of the company. We believe CNQ can be a solid longterm investment, and it can bring handsome rewards to its shareholders. However, CNQ should be considered as a longterm investment as the shortterm movements are highly volatile.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: EfsInvestment is a team of analysts. This article was written by Cagdas Ozcan, one of our equity analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.