Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Royal Dutch Shell plc (AMS:RDSA) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. It may sound complicated, but actually it is quite simple!
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
Crunching the numbers
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 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.
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
|Levered FCF ($, Millions)||US$12.9b||US$17.8b||US$23.4b||US$21.1b||US$19.8b||US$18.9b||US$18.3b||US$17.9b||US$17.7b||US$17.5b|
|Growth Rate Estimate Source||Analyst x15||Analyst x14||Analyst x5||Analyst x2||Est @ -6.49%||Est @ -4.48%||Est @ -3.08%||Est @ -2.09%||Est @ -1.41%||Est @ -0.92%|
|Present Value ($, Millions) Discounted @ 8.3%||US$11.9k||US$15.2k||US$18.4k||US$15.4k||US$13.3k||US$11.7k||US$10.5k||US$9.5k||US$8.6k||US$7.9k|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$122b
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 0.2%. We discount the terminal cash flows to today's value at a cost of equity of 8.3%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$17b× (1 + 0.2%) ÷ (8.3%– 0.2%) = US$217b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$217b÷ ( 1 + 8.3%)10= US$98b
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$220b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of €15.4, the company appears quite good value at a 34% 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.
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 Royal Dutch Shell 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 8.3%, which is based on a levered beta of 1.544. 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.
Although the valuation of a company is important, it is only one of many factors that you need to assess for 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. Can we work out why the company is trading at a discount to intrinsic value? For Royal Dutch Shell, we've compiled three additional items you should consider:
- Risks: For example, we've discovered 3 warning signs for Royal Dutch Shell (1 is concerning!) that you should be aware of before investing here.
- Future Earnings: How does RDSA'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 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 Dutch 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. 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.
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