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In this article I am going to calculate the intrinsic value of BHP Billiton Limited (ASX:BHP) by taking the foreast future cash flows of the company and discounting them back to today’s value. I will be using the Discounted Cash Flows (DCF) model. It may sound complicated, but actually it is quite simple! Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. If you are reading this and its not August 2018 then I highly recommend you check out the latest calculation for BHP Billiton by following the link below.

See our latest analysis for BHP Billiton

Is BHP fairly valued?

I’m using the 2-stage growth model, which simply means we take in account two stages of company’s growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have perpetual stable growth rate. To start off with we need to estimate the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. The sum of these cash flows is then discounted to today’s value.

5-year cash flow estimate

Present Value of 5-year Cash Flow (PVCF)= US$41.79b

After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (2.8%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 10.3%.

Terminal Value (TV) = FCF₂₀₂₂ × (1 + g) ÷ (r – g) = US$13.62b × (1 + 2.8%) ÷ (10.3% – 2.8%) = US$185.33b

Present Value of Terminal Value (PVTV) = TV / (1 + r)⁵ = US$185.33b ÷ ( 1 + 10.3%)⁵ = US$113.39b

The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is US$155.18b. To get the intrinsic value per share, we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR. This results in an intrinsic value in the company’s reported currency of $29.15. However, BHP’s primary listing is in Australia, and 1 share of BHP in USD represents 1.361 ( USD/ AUD) share of NYSE:BHP, so the intrinsic value per share in AUD is A$39.69. Compared to the current share price of A$33.42, the stock is about right, perhaps slightly undervalued at a 15.8% discount to what it is available for right now.

The assumptions

I’d like to point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. If you don’t agree with my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at BHP Billiton as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 10.3%, which is based on a levered beta of 1.045. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

Next Steps:

Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. For BHP, I’ve put together three important factors you should further research:

1. Financial Health: Does BHP 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 BHP’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.

3. Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of BHP? 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 does a DCF calculation for every AU stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.

To help readers see past 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. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.