Estimating The Intrinsic Value Of Orion Engineered Carbons S.A. (NYSE:OEC)

Key Insights

• Orion Engineered Carbons' estimated fair value is US$19.4 based on 2 Stage Free Cash Flow to Equity
• Current share price of US$21.0 suggests Orion Engineered Carbons is trading close to its fair value
• Analyst price target for OEC is US$27.20 which is 40% above our fair value estimate

Today we will run through one way of estimating the intrinsic value of Orion Engineered Carbons S.A. (NYSE:OEC) by taking the expected future cash flows and discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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 still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

View our latest analysis for Orion Engineered Carbons

The Model

We're using the 2-stage growth model, which simply means we take in account two stages of 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. 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.

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 value in today's dollars:

10-year free cash flow (FCF) forecast

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	US$71.8m	US$79.8m	US$85.7m	US$90.7m	US$94.9m	US$98.5m	US$101.8m	US$104.7m	US$107.5m	US$110.1m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Est @ 7.42%	Est @ 5.79%	Est @ 4.65%	Est @ 3.85%	Est @ 3.29%	Est @ 2.89%	Est @ 2.62%	Est @ 2.43%
Present Value ($, Millions) Discounted @ 9.5%	US$65.5	US$66.6	US$65.3	US$63.1	US$60.3	US$57.2	US$54.0	US$50.7	US$47.6	US$44.5

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$575m

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 9.5%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$110m× (1 + 2.0%) ÷ (9.5%– 2.0%) = US$1.5b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$1.5b÷ ( 1 + 9.5%)¹⁰= US$605m

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$1.2b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$21.0, the company appears around fair value at the time of writing. 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.

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Orion Engineered Carbons 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 9.5%, 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.

SWOT Analysis for Orion Engineered Carbons

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. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Orion Engineered Carbons, there are three fundamental items you should explore:

1. Risks: For example, we've discovered 3 warning signs for Orion Engineered Carbons (2 are concerning!) that you should be aware of before investing here.
2. Future Earnings: How does OEC'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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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.