Does the June price of Southwestern Energy Company (NYSE:SWN) stock reflect what it’s really worth? Today we are going to estimate the intrinsic value of the stock by taking the expected future cash flows of the business and discounting them to today’s value. One way to do this is to use the discounted cash flow (DCF) model. There really isn’t much to do, although it may seem quite complex.
We generally believe that the value of a company is the present value of all the cash it will generate in the future. However, a DCF is just one of many evaluation metrics, and it is not without its flaws. If you want to know more about discounted cash flow, the rationale for this calculation can be read in detail in the Simply Wall St analysis template.
Check out our latest analysis for Southwestern Energy
What is the estimated valuation?
We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “sustained growth”. To start, we need to estimate the cash flows for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, and so the sum of these future cash flows is then discounted to today’s value:
Estimated free cash flow (FCF) over 10 years
|Leveraged FCF ($, millions)||$1.08 billion||$1.66 billion||$1.92 billion||$868.0 million||$856.9 million||$854.2 million||$857.2 million||$864.3 million||$874.2 million||$886.3 million|
|Growth rate estimate Source||Analyst x8||Analyst x7||Analyst x2||Analyst x1||Is @ -1.28%||Is @ -0.32%||Is at 0.35%||Is at 0.82%||Is at 1.15%||Is at 1.38%|
|Present value (in millions of dollars) discounted at 8.6%||$991||$1,400||$1.5k||$625||$568||$521||$482||$447||$417||$389|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $7.3 billion
The second stage is also known as the terminal value, it is the cash flow of the business after the first stage. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 1.9%. We discount terminal cash flows to present value at a cost of equity of 8.6%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$886 million × (1 + 1.9%) ÷ (8.6%–1.9%) = US$14 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= $14 billion ÷ (1 + 8.6%)ten= US$6.0 billion
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is $13 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of $9.2, the company looks slightly undervalued at a 23% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.
The above calculation is highly dependent on two assumptions. One is the discount rate and the other is the cash flows. Part of investing is coming up with your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view Southwestern 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 factors in debt. In this calculation, we used 8.6%, which is based on a leveraged beta of 1.571. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Let’s move on :
Valuation is only one side of the coin in terms of crafting your investment thesis, and ideally it won’t be the only piece of analysis you look at for a company. DCF models are not the be-all and end-all of investment valuation. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under/overvalued?” For example, if the terminal value growth rate is adjusted slightly, it can significantly change the overall result. Can we understand why the company is trading at a discount to its intrinsic value? For Southwestern Energy, we have put together three relevant aspects that you should consider:
- Risks: Every business has them, and we’ve spotted 3 warning signs for Southwestern Energy (1 of which is potentially serious!) that you should know about.
- Future earnings: How does SWN’s growth rate compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
- Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of what you might be missing!
PS. Simply Wall St updates its DCF calculation for every US stock daily, so if you want to find the intrinsic value of any other stock, do a search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.