Hess Midstream LP (NYSE:HESM) Shares Could Be 26% Below Their Intrinsic Value Estimate

Key Insights

• Hess Midstream's estimated fair value is US$47.72 based on 2 Stage Free Cash Flow to Equity

• Hess Midstream is estimated to be 26% undervalued based on current share price of US$35.33

• Our fair value estimate is 27% higher than Hess Midstream's analyst price target of US$37.60

Does the April share price for Hess Midstream LP (NYSE:HESM) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. There's really not all that much to it, even though it might appear quite complex.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

View our latest analysis for Hess Midstream

The 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. To start off with, we need to estimate 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$677.7m	US$754.7m	US$782.0m	US$771.0m	US$757.0m	US$761.9m	US$770.6m	US$782.1m	US$795.6m	US$810.6m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x1	Analyst x1	Analyst x1	Est @ 0.65%	Est @ 1.14%	Est @ 1.49%	Est @ 1.73%	Est @ 1.90%
Present Value ($, Millions) Discounted @ 8.6%	US$624	US$640	US$611	US$555	US$502	US$466	US$434	US$406	US$380	US$357

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$5.0b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (2.3%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 8.6%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$811m× (1 + 2.3%) ÷ (8.6%– 2.3%) = US$13b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$13b÷ ( 1 + 8.6%)¹⁰= US$5.8b

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$11b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$35.3, the company appears a touch undervalued at a 26% 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.

dcf

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. 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 Hess Midstream 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 1.362. 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 Hess Midstream

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is well covered by earnings and cashflows.

• Dividend is in the top 25% of dividend payers in the market.

Weakness

• No major weaknesses identified for HESM.

Opportunity

• Annual earnings are forecast to grow faster than the American market.

• Trading below our estimate of fair value by more than 20%.

Threat

• Dividends are not covered by earnings.

• Revenue is forecast to grow slower than 20% per year.

Next Steps:

Whilst important, the DCF calculation 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. 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. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. Can we work out why the company is trading at a discount to intrinsic value? For Hess Midstream, we've put together three relevant elements you should look at:

1. Risks: We feel that you should assess the 2 warning signs for Hess Midstream we've flagged before making an investment in the company.

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

3. Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NYSE every day. If you want to find the calculation for other stocks 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.