Yahoo Finance Is There An Opportunity With Pacific Energy Limited’s (ASX:PEA) 42.15% Undervaluation?
How far off is Pacific Energy Limited (ASX:PEA) from its intrinsic value? Using the most recent financial data, I am going to take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them 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 December 2018 then I highly recommend you check out the latest calculation for Pacific Energy by following the link below.
View our latest analysis for Pacific Energy
Crunching the numbers
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. In the first stage we need to estimate the cash flows to the business over the next five years. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount the sum of these cash flows to arrive at a present value estimate.
5-year cash flow forecast
2019 | 2020 | 2021 | 2022 | 2023 | |
Levered FCF (A$, Millions) | A$19.85 | A$23.50 | A$25.70 | A$27.51 | A$29.44 |
Source | Analyst x2 | Analyst x1 | Analyst x1 | Est @ 7.03% | Est @ 7.03% |
Present Value Discounted @ 8.55% | A$18.29 | A$19.94 | A$20.09 | A$19.81 | A$19.53 |
Present Value of 5-year Cash Flow (PVCF)= AU$98m
The second stage is also known as Terminal Value, this is the business’s cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 2.8%. We discount this to today’s value at a cost of equity of 8.6%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = AU$29m × (1 + 2.8%) ÷ (8.6% – 2.8%) = AU$523m
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = AU$523m ÷ ( 1 + 8.6%)5 = AU$347m
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is AU$445m. In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number. This results in an intrinsic value of A$1.04. Compared to the current share price of A$0.60, the stock is quite good value at a 42% discount to what it is available for right now.
Important assumptions
Now 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 Pacific Energy 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 8.6%, which is based on a levered beta of 0.800. 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:
Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For PEA, I’ve put together three important factors you should look at:
Financial Health: Does PEA 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.
Future Earnings: How does PEA’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: Are there other high quality stocks you could be holding instead of PEA? 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.
