In this article we are going to estimate the intrinsic value of Devon Energy Corporation (NYSE:DVN) by projecting its future cash flows and then discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
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 still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
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.
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
2022
2023
2024
2025
2026
2027
2028
2029
2030
2031
Levered FCF ($, Millions)
US$4.30b
US$4.09b
US$3.71b
US$3.64b
US$3.62b
US$3.63b
US$3.65b
US$3.69b
US$3.74b
US$3.80b
Growth Rate Estimate Source
Analyst x9
Analyst x5
Analyst x3
Analyst x2
Est @ -0.56%
Est @ 0.2%
Est @ 0.73%
Est @ 1.1%
Est @ 1.36%
Est @ 1.54%
Present Value ($, Millions) Discounted @ 8.1%
US$4.0k
US$3.5k
US$2.9k
US$2.7k
US$2.4k
US$2.3k
US$2.1k
US$2.0k
US$1.9k
US$1.7k
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = US$25b
The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 8.1%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$63b÷ ( 1 + 8.1%)10= US$29b
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$54b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$42.7, 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.
NYSE:DVN Discounted Cash Flow November 29th 2021
Important assumptions
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. 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 Devon 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 8.1%, which is based on a levered beta of 1.407. 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.
Next Steps:
Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Can we work out why the company is trading at a discount to intrinsic value? For Devon Energy, we've put together three pertinent factors you should look at:
Risks: For example, we've discovered 6 warning signs for Devon Energy (1 shouldn't be ignored!) that you should be aware of before investing here.
Future Earnings: How does DVN'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 Solid Businesses: 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 business fundamentals to see if there are other companies you may not have considered!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NYSE every day. If you want to find the calculation for other stocks just search here.
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.
Have feedback on this article? Concerned about the content?Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
