West Texas Oil price just crossed US$80 for the first time in 7 years. Naturally, this re-ignited the interest in oil stocks that show the world they are not just dead yet, despite the climate activists shoveling dirt in their faces.
Although the oil price is back to the highs, some oil companies like Chevron Corporation (NYSE: CVX) might be undervalued. This article will examine that valuation from the discounted cash flow (DCF) perspective.
All About the Carbon
Chevron is joining the zero-emissions aspiration club. The company outlined a plan to reach net-zero emissions by 2050. So far, its lower-carbon operations are set to reach US$10b by 2028.
Yet, this prompted a downgrade from J.P. Morgan, as it reduced the rating from Overweight to Neutral, moving the price target from US$128 to US$111. Analyst Phil Gresh said that Chevron's plan doesn't appear to have offsets elsewhere in the portfolio.
Regarding renewable energy, the company doesn't see a lot of future in the wind and solar projects. CEO Michael Wirth reflected on these opportunities, saying that they cannot create value for their shareholders. Instead, he took a strong position in favor of green hydrogen – hydrogen-produced fuel obtained from water electrolysis using the energy from low carbon sources.
Chevron is set to announce the earnings results on October 29th with EPS estimates of US$2.16 and a revenue estimate of US$39.84b.
The Discounted Cash Flow (DCF) method
DCF method works by taking the expected future cash flows and discounting them to today's value.
Remember, though, that there are many ways to estimate a company's value, and a DCF is just one method. If you still have some burning questions about this type of valuation, look at the Simply Wall St analysis model.
We're using the 2-stage growth model, which means we consider two stages of the company's growth. In the initial period, the company may have a higher growth rate, and the second stage is usually assumed to have a stable growth rate.
In the first stage, we need to estimate the cash flows to the business over the next ten years. Where possible, we use analyst estimates, but when these aren't available, we extrapolate the previous free cash flow (FCF) from the last estimate or reported value.
We assume companies with shrinking free cash flow will slow their rate of shrinkage and that companies with growing free cash flow will see their growth rate slow over this period. We do this to reflect that growth tends to slow more early than in later years.
Generally, we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated worth in today's dollars:
10-year free cash flow (FCF) forecast
|Levered FCF ($, Millions)||US$20.0b||US$19.5b||US$21.5b||US$23.7b||US$24.8b||US$25.8b||US$26.7b||US$27.5b||US$28.2b||US$28.9b|
|Growth Rate Estimate Source||Analyst x12||Analyst x9||Analyst x1||Analyst x1||Est @ 4.9%||Est @ 4.02%||Est @ 3.4%||Est @ 2.97%||Est @ 2.67%||Est @ 2.45%|
|Present Value ($, Millions) Discounted @ 8.0%||US$18.5k||US$16.7k||US$17.1k||US$17.4k||US$16.9k||US$16.2k||US$15.5k||US$14.8k||US$14.1k||US$13.3k|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$160b
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 several 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 (2.0%) 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 8.0%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$29b× (1 + 2.0%) ÷ (8.0%– 2.0%) = US$484b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$484b÷ ( 1 + 8.0%)10= US$223b
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$384b.
In the final step, we divide the equity value by the number of shares outstanding. Relative to the current share price of US$107, the company appears relatively undervalued at a 46% discount to where the stock price trades currently.
The most critical inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. 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 complete picture of its potential performance.
Given that we are looking at Chevron as potential shareholders, the cost of equity is used as the discount rate rather than the cost of capital (or the weighted average cost of capital, WACC), which accounts for debt.
We've used 8.0% in this calculation, which is based on a levered beta of 1.389. Beta is a measure of a stock's volatility compared to the market as a whole.
While important, the DCF calculation is only one of many factors 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.
For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result.
For Chevron, we've compiled three essential factors you should look at:
- Risks: Be aware that Chevron is showing 2 warning signs in our investment analysis, which you should know about.
- Future Earnings: How does CVX's growth rate compare to its peers and the broader 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 NYSE every day. If you want to find the calculation for other stocks, just search here.
Simply Wall St analyst Stjepan Kalinic and Simply Wall St have no position in any of the companies mentioned. This article 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.