Cimarex Energy Co. (NYSE:XEC) Shares Could Be 47% Below Their Intrinsic Value Estimate

By
Simply Wall St
Published
August 15, 2021
Source: Shutterstock

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Cimarex Energy Co. (NYSE:XEC) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. There's really not all that much to it, even though it might appear quite complex.

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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for Cimarex Energy

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 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

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Levered FCF ($, Millions) US$1.15b US$1.01b US$908.0m US$893.4m US$888.6m US$890.6m US$897.3m US$907.4m US$920.0m US$934.4m
Growth Rate Estimate Source Analyst x5 Analyst x4 Analyst x1 Est @ -1.61% Est @ -0.53% Est @ 0.23% Est @ 0.75% Est @ 1.13% Est @ 1.38% Est @ 1.57%
Present Value ($, Millions) Discounted @ 8.8% US$1.1k US$849 US$704 US$637 US$582 US$536 US$496 US$461 US$430 US$401

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$6.2b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 (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 8.8%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$934m× (1 + 2.0%) ÷ (8.8%– 2.0%) = US$14b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$14b÷ ( 1 + 8.8%)10= US$6.0b

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$12b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$64.0, the company appears quite undervalued at a 47% 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.

dcf
NYSE:XEC Discounted Cash Flow August 16th 2021

Important assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own assumptions. 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 Cimarex Energy 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 8.8%, which is based on a levered beta of 1.450. 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.

Looking Ahead:

Although the valuation of a company is important, it is only one of many factors that you need to assess for 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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Why is the intrinsic value higher than the current share price? For Cimarex Energy, we've put together three pertinent aspects you should consider:

  1. Risks: Every company has them, and we've spotted 1 warning sign for Cimarex Energy you should know about.
  2. Future Earnings: How does XEC'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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