Stock Analysis

An Intrinsic Calculation For Pharos Energy plc (LON:PHAR) Suggests It's 46% Undervalued

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LSE:PHAR
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Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Pharos Energy plc (LON:PHAR) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for Pharos Energy

Is Pharos Energy 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. 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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) forecast

2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
Levered FCF ($, Millions) US$8.38m US$33.6m US$40.6m US$34.1m US$24.2m US$22.5m US$21.4m US$20.8m US$20.4m US$20.3m
Growth Rate Estimate Source Analyst x3 Analyst x2 Analyst x2 Analyst x2 Analyst x1 Est @ -7.06% Est @ -4.64% Est @ -2.95% Est @ -1.76% Est @ -0.94%
Present Value ($, Millions) Discounted @ 10% US$7.6 US$27.6 US$30.1 US$22.9 US$14.7 US$12.4 US$10.7 US$9.4 US$8.4 US$7.5

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$151m

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.0%. We discount the terminal cash flows to today's value at a cost of equity of 10%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$20m× (1 + 1.0%) ÷ (10%– 1.0%) = US$217m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$217m÷ ( 1 + 10%)10= US$81m

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$232m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of UK£0.2, the company appears quite undervalued at a 46% 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.

dcf
LSE:PHAR Discounted Cash Flow February 9th 2021

Important 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 Pharos 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 10%, which is based on a levered beta of 1.580. 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:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. 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 sitting below the intrinsic value? For Pharos Energy, there are three relevant items you should look at:

  1. Risks: Be aware that Pharos Energy is showing 3 warning signs in our investment analysis , you should know about...
  2. Future Earnings: How does PHAR'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the LSE every day. If you want to find the calculation for other stocks just search here.

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