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. I will use 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. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
Is Gazprom 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 are 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 (RUB, Millions)||RUруб202k||RUруб570k||RUруб614k||RUруб678k||RUруб712k||RUруб754k||RUруб805k||RUруб863k||RUруб928k||RUруб1.0m|
|Growth Rate Estimate Source||Analyst x5||Analyst x7||Analyst x4||Analyst x3||Analyst x2||Est @ 5.96%||Est @ 6.71%||Est @ 7.23%||Est @ 7.59%||Est @ 7.85%|
|Present Value (RUB, Millions) Discounted @ 22.41%||RUруб165k||RUруб380k||RUруб335k||RUруб302k||RUруб259k||RUруб224k||RUруб195k||RUруб171k||RUруб150k||RUруб133k|
Present Value of 10-year Cash Flow (PVCF)= RUB2.31t
“Est” = FCF growth rate estimated by Simply Wall St
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 10-year government bond rate of 8.4%. We discount the terminal cash flows to today’s value at a cost of equity of 22.4%.
Terminal Value (TV) = FCF2029 × (1 + g) ÷ (r – g) = RUруб1.0t × (1 + 8.4%) ÷ (22.4% – 8.4%) = RUруб7.8t
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = RUBRUруб7.8t ÷ ( 1 + 22.4%)10 = RUB1.03t
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is RUB3.34t. The last step is to then divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate of RUB151.24. Compared to the current share price of RUB158.33, the company appears around fair value at the time of writing. DCFs are imprecise instruments though, rather like a telescope – move a few degrees and end up in a different galaxy. Do keep this in mind.
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 22.4%, which is based on a levered beta of 1.482. 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, DCF calculation shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. 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. For Gazprom, I’ve compiled three important factors you should further examine:
- Financial Health: Does GAZP have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- 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 High Quality Alternatives: Are there other high quality stocks you could be holding instead of GAZP? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. Simply Wall St updates its DCF calculation for every RU stock every day, so if you want to find the intrinsic value of any other stock just search here.
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If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.