Today we will run through one way of estimating the intrinsic value of Australis Oil & Gas Limited (ASX:ATS) by projecting its future cash flows and then discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.
We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. 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.
What's the estimated valuation?
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, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) forecast
|Levered FCF ($, Millions)||-US$500.1k||US$999.9k||US$1.87m||US$3.02m||US$4.35m||US$5.71m||US$7.01m||US$8.16m||US$9.16m||US$10.0m|
|Growth Rate Estimate Source||Analyst x2||Analyst x1||Est @ 87.09%||Est @ 61.64%||Est @ 43.83%||Est @ 31.36%||Est @ 22.63%||Est @ 16.52%||Est @ 12.24%||Est @ 9.25%|
|Present Value ($, Millions) Discounted @ 11%||-US$0.5||US$0.8||US$1.4||US$2.0||US$2.6||US$3.1||US$3.4||US$3.6||US$3.6||US$3.6|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$23m
The second stage is also known as Terminal Value, this is the business's cash flow after 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 5-year average of the 10-year government bond yield (2.3%) 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 11%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$10m× (1 + 2.3%) ÷ (11%– 2.3%) = US$120m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$120m÷ ( 1 + 11%)10= US$43m
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$66m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of AU$0.06, the company appears quite good value at a 36% 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 calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Australis Oil & Gas 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 11%, which is based on a levered beta of 1.417. 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.
Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or 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 sitting below the intrinsic value? For Australis Oil & Gas, we've compiled three additional items you should further examine:
- Risks: As an example, we've found 3 warning signs for Australis Oil & Gas that you need to consider before investing here.
- Future Earnings: How does ATS'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.
- Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!
PS. Simply Wall St updates its DCF calculation for every Australian stock every day, so if you want to find the intrinsic value of any other stock just search here.
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