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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 long-term 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 52-week range of $25.01 to $32.33. It has a market cap of about $35.2 billion. The trailing 12-month 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 five-star 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 five-year 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 long-term projects. It is also frequently used to price fair-valued 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 current-period 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 five-year growth forecast is 8%. Book value per share is $22.13.

Fair Value Estimator

V0

E0

$1.99

V1

E0 (1+g)/(1+r)

$1.94

V2

E0((1+g)/(1+r))2

$1.88

V3

E0((1+g)/(1+r))3

$1.83

V4

E0((1+g)/(1+r))4

$1.78

V5

E0((1+g)/(1+r))5

$1.74

D

E0(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 low-debt and debt-loaded company. The lower boundary does not include the book value. According to my five-year discounted-earnings-plus-book-value model, the fair-value 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 long-term 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 long-term investment, and it can bring handsome rewards to its shareholders. However, CNQ should be considered as a long-term investment as the short-term movements are highly volatile.

Source: How Much Is Canadian Natural Resources Worth?