Today we will run through one way of estimating the intrinsic value of ConocoPhillips Company (NYSE:COP) by estimating the company’s future cash flows and discounting them to their present value. I will use the Discounted Cash Flow (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward.
We generally believe that a company’s value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. 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.
Crunching the numbers
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.
Generally we assume that a dollar today is more valuable than a dollar in the future, 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
|Levered FCF ($, Millions)||US$4.46b||US$4.77b||US$4.83b||US$5.30b||US$5.52b||US$5.71b||US$5.88b||US$6.03b||US$6.17b||US$6.31b|
|Growth Rate Estimate Source||Analyst x11||Analyst x8||Analyst x5||Analyst x4||Est @ 4.22%||Est @ 3.47%||Est @ 2.95%||Est @ 2.59%||Est @ 2.34%||Est @ 2.16%|
|Present Value ($, Millions) Discounted @ 7.5%||US$4.2k||US$4.1k||US$3.9k||US$4.0k||US$3.8k||US$3.7k||US$3.5k||US$3.4k||US$3.2k||US$3.1k|
Present Value of 10-year Cash Flow (PVCF) = US$37b
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 10-year government bond rate (1.7%) 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 7.5%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = US$6.3b× (1 + 1.7%) ÷ 7.5%– 1.7%) = US$111b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$111b÷ ( 1 + 7.5%)10= US$54b
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$90b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of US$63.7, the company appears a touch undervalued at a 23% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
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 ConocoPhillips 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 7.5%, which is based on a levered beta of 1.065. 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.
Although the valuation of a company is important, 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?” If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. What is the reason for the share price to differ from the intrinsic value? For ConocoPhillips, I’ve put together three further factors you should further examine:
- Financial Health: Does COP have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does COP’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.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of COP? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!