Are Investors Undervaluing SeaBird Exploration Plc (OB:SBX) By 43%?

Today we’ll do a simple run through of a valuation method used to estimate the attractiveness of SeaBird Exploration Plc (OB:SBX) as an investment opportunity by taking the expected future cash flows and discounting them to their present 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.

We generally believe that a company’s value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

See our latest analysis for SeaBird Exploration

The method

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 start off with, we need to estimate 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
Levered FCF ($, Millions) -US$6.8m US$10.5m US$6.30m US$4.30m US$3.35m US$2.84m US$2.55m US$2.36m US$2.25m US$2.18m
Growth Rate Estimate Source Analyst x2 Analyst x2 Analyst x1 Est @ -31.74% Est @ -22.02% Est @ -15.22% Est @ -10.46% Est @ -7.13% Est @ -4.79% Est @ -3.16%
Present Value ($, Millions) Discounted @ 14% -US$6.0 US$8.0 US$4.2 US$2.5 US$1.7 US$1.3 US$1.0 US$0.8 US$0.7 US$0.6

(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$14m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 10-year government bond rate of 0.6%. We discount the terminal cash flows to today’s value at a cost of equity of 14%.

Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = US$2.2m× (1 + 0.6%) ÷ 14%– 0.6%) = US$16m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$16m÷ ( 1 + 14%)10= US$4.3m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$18m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of kr0.2, the company appears quite undervalued at a 43% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula – garbage in, garbage out.

OB:SBX Intrinsic value April 17th 2020
OB:SBX Intrinsic value April 17th 2020

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. You don’t have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 SeaBird Exploration 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 14%, which is based on a levered beta of 1.456. 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 SeaBird Exploration, We’ve put together three relevant factors you should look at:

  1. Risks: For instance, we’ve identified 5 warning signs for SeaBird Exploration (3 can’t be ignored) you should be aware of.
  2. Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for SBX’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
  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 NO 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.