Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Public Joint Stock Company Gazprom (MCX:GAZP) 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. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.
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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
|Levered FCF (RUB, Millions)||₽57.8b||₽272.1b||₽492.6b||₽874.6b||₽1.12t||₽1.32t||₽1.52t||₽1.72t||₽1.91t||₽2.10t|
|Growth Rate Estimate Source||Analyst x8||Analyst x8||Analyst x4||Analyst x3||Analyst x3||Est @ 18.13%||Est @ 15%||Est @ 12.8%||Est @ 11.27%||Est @ 10.2%|
|Present Value (RUB, Millions) Discounted @ 22%||₽47.3k||₽181.7k||₽269.0k||₽390.3k||₽408.2k||₽394.2k||₽370.5k||₽341.5k||₽310.6k||₽279.8k|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ₽3.0t
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. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (7.7%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 22%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = ₽2.1t× (1 + 7.7%) ÷ (22%– 7.7%) = ₽15t
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= ₽15t÷ ( 1 + 22%)10= ₽2.1t
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is ₽5.0t. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of ₽213, the company appears about fair value at a 0.4% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
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 Gazprom 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 22%, which is based on a levered beta of 1.733. 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 ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Gazprom, we've compiled three important items you should further examine:
- Risks: Case in point, we've spotted 3 warning signs for Gazprom you should be aware of.
- Future Earnings: How does GAZP'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the MISX 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. 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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