In this article we are going to estimate the intrinsic value of PJSC LUKOIL (MCX:LKOH) by taking the expected future cash flows and discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. 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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
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 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.
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) forecast
|Levered FCF (RUB, Millions)||₽344.5b||₽420.8b||₽404.9b||₽482.3b||₽526.8b||₽573.8b||₽624.0b||₽677.6b||₽735.3b||₽797.3b|
|Growth Rate Estimate Source||Analyst x10||Analyst x8||Analyst x4||Analyst x3||Est @ 9.22%||Est @ 8.94%||Est @ 8.74%||Est @ 8.6%||Est @ 8.51%||Est @ 8.44%|
|Present Value (RUB, Millions) Discounted @ 20%||₽287.0k||₽291.9k||₽233.9k||₽232.1k||₽211.2k||₽191.6k||₽173.5k||₽157.0k||₽141.9k||₽128.1k|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ₽2.0t
The second stage is also known as Terminal Value, this is the business's cash flow after 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 8.3%. We discount the terminal cash flows to today's value at a cost of equity of 20%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = ₽797b× (1 + 8.3%) ÷ (20%– 8.3%) = ₽7.3t
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= ₽7.3t÷ ( 1 + 20%)10= ₽1.2t
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is ₽3.2t. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of ₽4.9k, the company appears about fair value at a 0.5% 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.
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 PJSC LUKOIL 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 20%, which is based on a levered beta of 1.173. 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.
Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or 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 PJSC LUKOIL, we've put together three fundamental elements you should further research:
- Risks: For instance, we've identified 3 warning signs for PJSC LUKOIL that you should be aware of.
- Future Earnings: How does LKOH'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 Russian stock every day, so if you want to find the intrinsic value of any other stock just search here.
If you decide to trade PJSC LUKOIL, use the lowest-cost* platform that is rated #1 Overall by Barron’s, Interactive Brokers. Trade stocks, options, futures, forex, bonds and funds on 135 markets, all from a single integrated account.
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.
*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email firstname.lastname@example.org.