Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Central Petroleum Limited (ASX:CTP) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
We're 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 a stable growth rate. In the first stage we need to estimate the cash flows to the business over the next ten years. 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
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
Levered FCF (A$, Millions)
AU$28.0m
-AU$5.00m
AU$3.00m
AU$2.41m
AU$2.09m
AU$1.91m
AU$1.81m
AU$1.76m
AU$1.73m
AU$1.72m
Growth Rate Estimate Source
Analyst x1
Analyst x1
Analyst x1
Est @ -19.68%
Est @ -13.13%
Est @ -8.54%
Est @ -5.33%
Est @ -3.08%
Est @ -1.51%
Est @ -0.41%
Present Value (A$, Millions) Discounted @ 8.8%
AU$25.7
-AU$4.2
AU$2.3
AU$1.7
AU$1.4
AU$1.2
AU$1.0
AU$0.9
AU$0.8
AU$0.7
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = AU$32m
After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 2.2%. We discount the terminal cash flows to today's value at a cost of equity of 8.8%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$26m÷ ( 1 + 8.8%)10= AU$11m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$43m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of AU$0.06, the company appears around fair value at the time of writing. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.
ASX:CTP Discounted Cash Flow April 19th 2024
Important Assumptions
Now 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 Central Petroleum 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 8.8%, which is based on a levered beta of 1.445. 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 Central Petroleum
Strength
Net debt to equity ratio below 40%.
Weakness
Interest payments on debt are not well covered.
Opportunity
Annual revenue is forecast to grow faster than the Australian market.
Good value based on P/E ratio compared to estimated Fair P/E ratio.
Significant insider buying over the past 3 months.
Threat
Debt is not well covered by operating cash flow.
Looking Ahead:
Although the valuation of a company is important, it shouldn't be the only metric you look at when researching 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 example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Central Petroleum, we've put together three pertinent factors you should further research:
Risks: We feel that you should assess the 3 warning signs for Central Petroleum (2 make us uncomfortable!) we've flagged before making an investment in the company.
Future Earnings: How does CTP'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 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 Australian stock every day, so if you want to find the intrinsic value of any other stock just search here.
Have feedback on this article? Concerned about the content?Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.
