Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Petrolia SE (OB:PSE) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To start off with, we need to estimate the next ten years of cash flows. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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) estimate
|Levered FCF ($, Millions)||US$5.21m||US$4.88m||US$4.68m||US$4.56m||US$4.50m||US$4.47m||US$4.46m||US$4.48m||US$4.50m||US$4.53m|
|Growth Rate Estimate Source||Est @ -9.56%||Est @ -6.34%||Est @ -4.1%||Est @ -2.52%||Est @ -1.42%||Est @ -0.65%||Est @ -0.11%||Est @ 0.27%||Est @ 0.53%||Est @ 0.72%|
|Present Value ($, Millions) Discounted @ 15%||US$4.5||US$3.7||US$3.1||US$2.6||US$2.2||US$1.9||US$1.7||US$1.5||US$1.3||US$1.1|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$23m
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 1.2%. We discount the terminal cash flows to today's value at a cost of equity of 15%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$4.5m× (1 + 1.2%) ÷ (15%– 1.2%) = US$33m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$33m÷ ( 1 + 15%)10= US$8.2m
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$31m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of kr4.6, the company appears about fair value at a 2.9% 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.
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 these result, have a go at the calculation yourself and play with the 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 Petrolia 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 15%, which is based on a levered beta of 2.000. 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.
Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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. For Petrolia, we've compiled three pertinent elements you should explore:
- Risks: You should be aware of the 2 warning signs for Petrolia we've uncovered before considering an investment in the company.
- 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!
- Other Top Analyst Picks: Interested to see what the analysts are thinking? Take a look at our interactive list of analysts' top stock picks to find out what they feel might have an attractive future outlook!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the OB every day. If you want to find the calculation for other stocks just search here.
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.