Strike Energy Limited's (ASX:STX) Intrinsic Value Is Potentially 37% Above Its Share Price

Key Insights

• Strike Energy's estimated fair value is AU$0.55 based on 2 Stage Free Cash Flow to Equity
• Current share price of AU$0.41 suggests Strike Energy is potentially 27% undervalued
• Our fair value estimate is 1.7% higher than Strike Energy's analyst price target of AU$0.55

Today we will run through one way of estimating the intrinsic value of Strike Energy Limited (ASX:STX) by estimating the company's future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. It may sound complicated, but actually it is quite simple!

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 still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out our latest analysis for Strike Energy

The Calculation

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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	-AU$78.2m	-AU$52.6m	AU$10.3m	AU$209.2m	AU$163.4m	AU$138.6m	AU$124.7m	AU$116.7m	AU$112.2m	AU$109.8m
Growth Rate Estimate Source	Analyst x3	Analyst x3	Analyst x2	Analyst x2	Analyst x1	Est @ -15.18%	Est @ -10.02%	Est @ -6.41%	Est @ -3.88%	Est @ -2.12%
Present Value (A$, Millions) Discounted @ 7.8%	-AU$72.6	-AU$45.2	AU$8.2	AU$155	AU$112	AU$88.3	AU$73.7	AU$64.0	AU$57.1	AU$51.8

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$493m

After calculating the present value of future cash flows in the initial 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 5-year average of the 10-year government bond yield (2.0%) 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 7.8%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$110m× (1 + 2.0%) ÷ (7.8%– 2.0%) = AU$1.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$1.9b÷ ( 1 + 7.8%)¹⁰= AU$913m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$1.4b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of AU$0.4, 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.

Important Assumptions

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 Strike Energy 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 7.8%, which is based on a levered beta of 1.158. 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.

SWOT Analysis for Strike Energy

Moving On:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Can we work out why the company is trading at a discount to intrinsic value? For Strike Energy, there are three essential factors you should look at:

1. Risks: You should be aware of the 3 warning signs for Strike Energy (2 don't sit too well with us!) we've uncovered before considering an investment in the company.
2. Future Earnings: How does STX'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 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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.