NYSE:SWN) by taking the forecast future cash flows of the company and discounting them back to today’s value. We will use the Discounted Cash Flow (DCF) model on this occasion. Before you think you won’t be able to understand it, just read on! It’s actually much less complex than you’d imagine.” data-reactid=”28″>Today we will run through one way of estimating the intrinsic value of Southwestern Energy Company (NYSE:SWN) by taking the forecast future cash flows of the company and discounting them back to today’s value. We will use the Discounted Cash Flow (DCF) model on this occasion. Before you think you won’t be able to understand it, just read on! It’s actually much less complex than you’d imagine.
Simply Wall St analysis model.” data-reactid=”29″>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 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 Southwestern Energy ” data-reactid=”30″> View our latest analysis for Southwestern Energy
Step by step through the calculation
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second ‘steady growth’ period. 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, and so the sum of these future cash flows is then discounted to today’s value:
10-year free cash flow (FCF) forecast
| 2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | |
| Levered FCF ($, Millions) | US$115.1m | US$106.1m | US$272.1m | US$250.6m | US$239.0m | US$232.9m | US$230.2m | US$230.0m | US$231.3m | US$233.8m |
| Growth Rate Estimate Source | Analyst x7 | Analyst x3 | Analyst x1 | Analyst x1 | Est @ -4.62% | Est @ -2.57% | Est @ -1.13% | Est @ -0.13% | Est @ 0.58% | Est @ 1.07% |
| Present Value ($, Millions) Discounted @ 14% | US$101 | US$82.3 | US$186 | US$151 | US$127 | US$109 | US$94.5 | US$83.2 | US$73.6 | US$65.5 |
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 14%.
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$1.7b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$2.6, the company appears about fair value at a 6.9% discount to where the stock price trades currently. 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.
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 Southwestern 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 14%, which is based on a levered beta of 1.887. 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:
Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn’t be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to “what assumptions need to be true for this stock to be under/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. For Southwestern Energy, we’ve put together three further elements you should consider:
- Risks: Every company has them, and we’ve spotted 2 warning signs for Southwestern Energy you should know about.
- Future Earnings: How does SWN’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!
search here.” data-reactid=”70″>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.
Get in touch with us directly. Alternatively, email [email protected].” data-reactid=”71″>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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