Is Marathon Oil Corporation (NYSE:MRO) Trading At A 42% Discount?

Key Insights

• Marathon Oil's estimated fair value is US$46.4 based on 2 Stage Free Cash Flow to Equity
• Current share price of US$26.7 suggests Marathon Oil is 42% undervalued
• Analyst price target for MRO is US$34.30 which is 26% below our fair value estimate

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Marathon Oil Corporation (NYSE:MRO) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back to today's value. This will be done using 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 would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. 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.

See our latest analysis for Marathon Oil

Is Marathon Oil 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 begin with, we have to get estimates of 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

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	US$3.46b	US$2.93b	US$2.62b	US$2.45b	US$2.36b	US$2.31b	US$2.28b	US$2.28b	US$2.30b	US$2.32b
Growth Rate Estimate Source	Analyst x5	Analyst x4	Analyst x2	Est @ -6.46%	Est @ -3.93%	Est @ -2.16%	Est @ -0.92%	Est @ -0.05%	Est @ 0.56%	Est @ 0.99%
Present Value ($, Millions) Discounted @ 9.4%	US$3.2k	US$2.4k	US$2.0k	US$1.7k	US$1.5k	US$1.3k	US$1.2k	US$1.1k	US$1.0k	US$944

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$16b

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. 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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 9.4%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$2.3b× (1 + 2.0%) ÷ (9.4%– 2.0%) = US$32b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$32b÷ ( 1 + 9.4%)¹⁰= US$13b

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 US$29b. 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$26.7, the company appears quite good value at a 42% 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.

Important Assumptions

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 Marathon Oil 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 9.4%, which is based on a levered beta of 1.332. 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.

SWOT Analysis for Marathon Oil

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. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For Marathon Oil, we've put together three essential items you should further examine:

1. Risks: Every company has them, and we've spotted 2 warning signs for Marathon Oil (of which 1 doesn't sit too well with us!) you should know about.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for MRO's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
3. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St 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. Simply Wall St has no position in any stocks mentioned.