Step by step through the calculationI’m 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 perpetual stable growth rate. In the first stage we need to estimate the cash flows to the business over the next five years. Where possible I use analyst estimates, but when these aren’t available I have extrapolated the previous free cash flow (FCF) from the year before. For this growth rate I used the average annual growth rate over the past five years, but capped at a reasonable level. The sum of these cash flows is then discounted to today’s value.
5-year cash flow forecast
|Levered FCF (A$, Millions)||A$12.60||A$18.80||A$23.70||A$25.04||A$26.46|
|Source||Analyst x2||Analyst x2||Analyst x1||Extrapolated @ (5.67%)||Extrapolated @ (5.67%)|
|Present Value Discounted @ 8.55%||A$11.61||A$15.95||A$18.53||A$18.03||A$17.55|
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = A$26.46 × (1 + 2.8%) ÷ (8.6% – 2.8%) = A$470.47 Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = A$470.47 / ( 1 + 8.6%)5 = A$312.09The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is A$393.77. To get the intrinsic value per share, we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR. This results in an intrinsic value of A$0.92. Compared to the current share price of A$0.57, the stock is quite undervalued at a 37.91% discount to what it is available for right now.
Important assumptionsNow the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 Pacific Energy 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 8.6%, which is based on a levered beta of 0.800. 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:Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For PEA, I’ve put together three relevant factors you should look at:
- Financial Health: Does PEA 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.
- Future Earnings: How does PEA’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 High Quality Alternatives: Are there other high quality stocks you could be holding instead of PEA? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!