Today we will run through one way of estimating the intrinsic value of Diamondback Energy, Inc. (NASDAQ:FANG) by estimating the company's future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. There's really not all that much to it, even though it might appear quite complex.
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. Anyone interested in learning a bit more about intrinsic value should have a read of 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, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) forecast
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
Levered FCF ($, Millions)
US$3.15b
US$3.04b
US$2.92b
US$2.51b
US$2.41b
US$2.35b
US$2.33b
US$2.33b
US$2.34b
US$2.37b
Growth Rate Estimate Source
Analyst x12
Analyst x10
Analyst x4
Analyst x2
Est @ -4.23%
Est @ -2.32%
Est @ -0.98%
Est @ -0.04%
Est @ 0.62%
Est @ 1.08%
Present Value ($, Millions) Discounted @ 8.6%
US$2.9k
US$2.6k
US$2.3k
US$1.8k
US$1.6k
US$1.4k
US$1.3k
US$1.2k
US$1.1k
US$1.0k
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = US$17b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 2.2%. We discount the terminal cash flows to today's value at a cost of equity of 8.6%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$38b÷ ( 1 + 8.6%)10= US$17b
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$34b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$155, the company appears about fair value at a 0.7% 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.
NasdaqGS:FANG Discounted Cash Flow September 30th 2023
The 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. 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 Diamondback 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 8.6%, which is based on a levered beta of 1.280. 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 Diamondback Energy
Strength
Debt is well covered by earnings and cashflows.
Weakness
Earnings declined over the past year.
Dividend is low compared to the top 25% of dividend payers in the Oil and Gas market.
Opportunity
Good value based on P/E ratio and estimated fair value.
Threat
Dividends are not covered by cash flow.
Annual earnings are forecast to decline for the next 3 years.
Moving On:
Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Diamondback Energy, there are three further items you should look at:
Risks: We feel that you should assess the 4 warning signs for Diamondback Energy (1 is a bit concerning!) we've flagged before making an investment in the company.
Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for FANG's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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.
