Today I will be providing a simple run-through of the discounted cash flows (DCF) method to estimate the attractiveness of AGL Energy Limited (ASX:AGL) as an investment opportunity. If you want to learn more about this method, the basis for my calculations can be found in detail in the Simply Wall St analysis model. If you are reading this after January 2018 then I highly recommend you check out the latest calculation for AGL Energy here.

Is AGL fairly valued?

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. Firstly, I took the analyst consensus forecast of AGL’s levered free cash flow (FCF) over the next five years and discounted these figures at the cost of equity of 8.55%. When estimates weren’t available, I’ve extrapolated the average annual growth rate over the previous five years, capped at a reasonable level. This resulted in a present value of 5-year cash flow of A$3,277.5M. Keen to know how I arrived at this number? Take a look at our detailed analysis here.

Above is a visual representation of how AGL’s top and bottom lines are expected to move going forward, which should give you some color on AGL’s outlook. Secondly, I calculate the terminal value, which accounts for all the future cash flows after the five years. I think it’s suitable to use the 10-year government bond rate of 2.8% as the steady growth rate, which is rightly below GDP growth, but more towards the conservative side. The present value of the terminal value after discounting it back five years is A$11,980.9M.

The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is A$15,258.4M. In the final step we divide the equity value by the number of shares outstanding. This results in an intrinsic value of A$23.27, which, compared to the current share price of A$23.85, we find that AGL Energy is fair value, maybe slightly overvalued and not available at a discount at this time.

Next Steps:

Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company.

For AGL, I’ve put together three fundamental aspects you should look at:

• 1. Financial Health: Does AGL 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.

• 2. Future Earnings: How does AGL’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.

• 2. Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of AGL? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. The Simply Wall St app conducts a discounted cash flow for every stock on the ASX every 6 hours. If you want to find the calculation for other stocks just search here.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.