An Intrinsic Calculation For Magnolia Oil & Gas Corporation (NYSE:MGY) Suggests It's 25% Undervalued

By
Simply Wall St
Published
May 24, 2022
NYSE:MGY
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Today we will run through one way of estimating the intrinsic value of Magnolia Oil & Gas Corporation (NYSE:MGY) by estimating the company's future cash flows and discounting them to their present value. Our analysis will employ the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

View our latest analysis for Magnolia Oil & Gas

Is Magnolia Oil & Gas fairly valued?

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. 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) estimate

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Levered FCF ($, Millions) US$810.3m US$606.5m US$471.0m US$446.1m US$432.1m US$425.2m US$422.8m US$423.6m US$426.6m US$431.2m
Growth Rate Estimate Source Analyst x3 Analyst x4 Analyst x1 Est @ -5.29% Est @ -3.13% Est @ -1.61% Est @ -0.55% Est @ 0.19% Est @ 0.71% Est @ 1.07%
Present Value ($, Millions) Discounted @ 7.2% US$756 US$528 US$382 US$338 US$305 US$280 US$260 US$243 US$228 US$215

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$3.5b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (1.9%) 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 7.2%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$431m× (1 + 1.9%) ÷ (7.2%– 1.9%) = US$8.3b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$8.3b÷ ( 1 + 7.2%)10= US$4.1b

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$7.7b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of US$25.6, the company appears a touch undervalued at a 25% 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.

dcf
NYSE:MGY Discounted Cash Flow May 24th 2022

Important assumptions

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 Magnolia Oil & Gas 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 7.2%, which is based on a levered beta of 1.248. 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.

Moving On:

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. 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?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price sitting below the intrinsic value? For Magnolia Oil & Gas, we've put together three relevant factors you should assess:

  1. Risks: For example, we've discovered 1 warning sign for Magnolia Oil & Gas that you should be aware of before investing here.
  2. Future Earnings: How does MGY'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.
  3. 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!

PS. Simply Wall St updates its DCF calculation for every American stock every day, so if you want to find the intrinsic value of any other stock just search here.

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