An Intrinsic Calculation For Velesto Energy Berhad (KLSE:VELESTO) Suggests It's 27% Undervalued

In this article we are going to estimate the intrinsic value of Velesto Energy Berhad (KLSE:VELESTO) by taking the expected future cash flows and discounting them to today's value. This is done using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for Velesto Energy Berhad

Crunching the numbers

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 begin with, we have to get estimates of 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2020	2021	2022	2023	2024	2025	2026	2027	2028	2029
Levered FCF (MYR, Millions)	RM218.2m	RM218.7m	RM231.0m	RM241.5m	RM251.6m	RM261.6m	RM271.6m	RM281.6m	RM291.8m	RM302.2m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x2	Est @ 4.55%	Est @ 4.21%	Est @ 3.97%	Est @ 3.81%	Est @ 3.69%	Est @ 3.61%	Est @ 3.55%
Present Value (MYR, Millions) Discounted @ 17%	RM186	RM159	RM143	RM127	RM113	RM100	RM88.7	RM78.4	RM69.2	RM61.1

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = RM1.1b

After calculating the present value of future cash flows in the intial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 10-year government bond rate (3.4%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 17%.

Terminal Value (TV)= FCF₂₀₂₉ × (1 + g) ÷ (r – g) = RM302m× (1 + 3.4%) ÷ 17%– 3.4%) = RM2.2b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= RM2.2b÷ ( 1 + 17%)¹⁰= RM454m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is RM1.6b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of RM0.1, the company appears a touch undervalued at a 27% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

The assumptions

We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Velesto Energy Berhad 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 17%, which is based on a levered beta of 2.000. 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.

Next Steps:

Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. What is the reason for the share price to differ from the intrinsic value? For Velesto Energy Berhad, We've put together three essential factors you should further research:

1. Risks: Be aware that Velesto Energy Berhad is showing 2 warning signs in our investment analysis , and 1 of those shouldn't be ignored...
2. Future Earnings: How does VELESTO'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 High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. Simply Wall St updates its DCF calculation for every MY stock every day, so if you want to find the intrinsic value of any other stock just search here.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.