Today we’re going to go over one way to estimate the intrinsic value of Serica Energy plc (LON: SQZ) by projecting its future cash flows and then discounting them to today’s value. We will use the Discounted Cash Flow (DCF) model on this occasion. Patterns like these may seem beyond a layman’s comprehension, but they are fairly easy to follow.
Remember, however, that there are many ways to estimate the value of a business and that a DCF is just one method. If you still have burning questions about this type of valuation, take a look at the Simply Wall St.
Check out our latest analysis for Serica Energy
Crunch the numbers
We are going to use a two-step 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 “steady growth”. To begin with, we need to estimate the next ten years of cash flow. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated 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 down more in the early years than in subsequent years.
In general, we assume that a dollar today is worth more than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at an estimate of the present value:
10-year free cash flow (FCF) forecast
|Leverage FCF (£, Million)||United Kingdom £ 212.9 million||£ 153.3million in the UK||£ 112.0 million in the UK||United Kingdom £ 59.0 million||£ 43.7million in UK||United Kingdom £ 35.9 million||United Kingdom £ 31.5million||United Kingdom £ 28.9 million||UK £ 27.3million||United Kingdom £ 26.3million|
|Source of estimated growth rate||Analyst x3||Analyst x3||Analyst x1||Analyst x1||Is @ -25.93%||Is @ -17.88%||Is @ -12.25%||Is @ -8.3%||Is @ -5.54%||Is @ -3.61%|
|Present value (£, million) discounted at 7.0%||United Kingdom £ 199||United Kingdom £ 134||United Kingdom £ 91.5||United Kingdom £ 45.0||United Kingdom £ 31.2||United Kingdom £ 23.9||United Kingdom £ 19.6||United Kingdom £ 16.8||United Kingdom £ 14.9||United Kingdom £ 13.4|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = £ 589 million in the UK
The second stage is also known as 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 of the 10-year government bond yield of 0.9%. We discount the terminal cash flows to their present value at a cost of equity of 7.0%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = £ 26million × (1 + 0.9%) ÷ (7.0% – 0.9%) = £ 436million
Present value of terminal value (PVTV)= TV / (1 + r)ten= UK £ 436m ÷ (1 + 7.0%)ten= £ 222 million in the UK
The total value is the sum of the cash flows for the next ten years plus the final present value, which gives the total value of equity, which in this case is £ 811million. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of UK £ 2.3, the company appears to be slightly undervalued with a 24% discount to the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.
The above calculation is very dependent on two assumptions. One is the discount rate and the other is the cash flow. If you don’t agree with these results, try the calculation yourself and play with the 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 full picture of a company’s potential performance. Since we view Serica 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 takes debt into account. In this calculation, we used 7.0%, which is based on a leveraged beta of 1.243. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our beta from the industry average beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Move on :
While important, calculating DCF shouldn’t be the only metric you look at when looking for a business. It is not possible to achieve a rock-solid valuation with a DCF model. 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 dramatically change the overall result. Can we understand why the company trades at a discount to its intrinsic value? For Serica Energy, there are three additional things you should be looking at:
- Risks: As an example, we have found 3 warning signs for Serica Energy (1 is a bit of a nasty!) That you need to consider before investing here.
- Future benefits: How does SQZ’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus number for years to come by interacting with our free analyst growth expectations chart.
- Other strong companies: 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 trading fundamentals to see if there are other companies you may not have considered!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for each AIM share. If you want to find the calculation for other actions, just 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 using only 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 into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.