Calculating The Intrinsic Value Of Chennai Petroleum Corporation Limited (NSE:CHENNPETRO)

Key Insights

• Chennai Petroleum's estimated fair value is ₹759 based on 2 Stage Free Cash Flow to Equity
• Chennai Petroleum's ₹629 share price indicates it is trading at similar levels as its fair value estimate
• Chennai Petroleum's peers are currently trading at a premium of 214% on average

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Chennai Petroleum Corporation Limited (NSE:CHENNPETRO) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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.

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Step By Step Through The Calculation

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 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, 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) estimate

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (₹, Millions)	₹11.0b	₹16.0b	₹11.0b	₹9.95b	₹9.48b	₹9.36b	₹9.47b	₹9.74b	₹10.1b	₹10.6b
Growth Rate Estimate Source	Analyst x1	Analyst x1	Analyst x1	Est @ -9.57%	Est @ -4.68%	Est @ -1.25%	Est @ 1.14%	Est @ 2.82%	Est @ 4.00%	Est @ 4.82%
Present Value (₹, Millions) Discounted @ 13%	₹9.7k	₹12.5k	₹7.6k	₹6.1k	₹5.1k	₹4.5k	₹4.0k	₹3.7k	₹3.4k	₹3.1k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ₹60b

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. 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 6.7%. We discount the terminal cash flows to today's value at a cost of equity of 13%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = ₹11b× (1 + 6.7%) ÷ (13%– 6.7%) = ₹181b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= ₹181b÷ ( 1 + 13%)¹⁰= ₹53b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is ₹113b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of ₹629, the company appears about fair value at a 17% 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.

The Assumptions

Now 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 Chennai Petroleum 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 13%, which is based on a levered beta of 0.863. 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.

Check out our latest analysis for Chennai Petroleum

SWOT Analysis for Chennai Petroleum

Looking Ahead:

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. 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. For Chennai Petroleum, there are three essential aspects you should assess:

1. Risks: Case in point, we've spotted 2 warning signs for Chennai Petroleum you should be aware of.
2. Future Earnings: How does CHENNPETRO'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 High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NSEI every day. If you want to find the calculation for other stocks 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.