Contact Energy Limited's (NZSE:CEN) Intrinsic Value Is Potentially 54% Above Its Share Price

In this article we are going to estimate the intrinsic value of Contact Energy Limited (NZSE:CEN) by projecting its future cash flows and then discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

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.

View our latest analysis for Contact Energy

The model

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (NZ$, Millions)	NZ$252.0m	NZ$116.0m	NZ$112.0m	NZ$386.0m	NZ$395.0m	NZ$403.4m	NZ$412.0m	NZ$420.8m	NZ$429.8m	NZ$439.0m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Analyst x1	Analyst x1	Analyst x1	Est @ 2.13%	Est @ 2.13%	Est @ 2.13%	Est @ 2.14%	Est @ 2.14%
Present Value (NZ$, Millions) Discounted @ 5.9%	NZ$238	NZ$103	NZ$94.3	NZ$307	NZ$296	NZ$286	NZ$276	NZ$266	NZ$256	NZ$247

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NZ$2.4b

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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 5.9%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = NZ$439m× (1 + 2.1%) ÷ (5.9%– 2.1%) = NZ$12b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= NZ$12b÷ ( 1 + 5.9%)¹⁰= NZ$6.7b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is NZ$9.1b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of NZ$7.6, the company appears quite good value at a 35% 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.

dcf

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. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Contact 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 5.9%, which is based on a levered beta of 0.800. 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.

Moving On:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Contact Energy, we've put together three essential aspects you should assess:

1. Risks: For example, we've discovered 3 warning signs for Contact Energy (1 is a bit unpleasant!) that you should be aware of before investing here.

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for CEN's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

3. 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 New Zealander stock every day, so if you want to find the intrinsic value of any other stock just search here.

This article by Simply Wall St is general in nature. 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.

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