Calculating The Intrinsic Value Of BHP Billiton Limited (ASX:BHP)

Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of BHP Billiton Limited (ASX:BHP) as an investment opportunity by taking the foreast future cash flows of the company and discounting them back to today's value. This is done using the discounted cash flows (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. Please also note that this article was written in January 2018 so be sure check out the updated calculation by following the link below. See our latest analysis for BHP Billiton

Is BHP fairly valued?

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. In the first stage we need to estimate the cash flows to the business over the next five years. For this I used the consensus of the analysts covering the stock, as you can see below. The sum of these cash flows is then discounted to today's value.

After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 2.8%. We discount this to today's value at a cost of equity of 10.8%.

The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is A$131,604. In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number. This results in an intrinsic value of A$31.07, which, compared to the current share price of A$31.66, we find that BHP Billiton is fair value, maybe slightly overvalued and not available at a discount at this time.

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don't agree with my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at BHP Billiton as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I've used 10.8%, which is based on a levered beta of 1.104. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

Next Steps:

Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. For BHP, I've compiled three relevant aspects you should further research:

• 1. Financial Health: Does BHP have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
• 2. Future Earnings: How does BHP'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.
• 2. Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of BHP? 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 does a DCF calculation for every AU stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article 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.