Today we are going to give a simple overview of a valuation method used to estimate the attractiveness of Shell plc (LON:SHEL) as an investment opportunity by taking expected future cash flows and discounting them to their current value. This will be done using the discounted cash flow (DCF) model. There really isn’t much to do, although it may seem quite complex.
Remember though that there are many ways to estimate the value of a business and a DCF is just one method. Anyone interested in learning a little more about intrinsic value should read the Simply Wall St Analysis Template.
See our latest analysis for Shell
Step by step in the calculation
We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “sustained growth”. To start, we need to estimate the cash flows for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.
Generally, we assume that a dollar today is worth more than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at an estimate of present value:
Estimated free cash flow (FCF) over 10 years
2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | |
Leveraged FCF ($, millions) | $29.7 billion | $28.1 billion | $25.3 billion | $19.7 billion | $23.8 billion | $22.6 billion | $21.9 billion | $21.4 billion | $21.2 billion | US$21.0 billion |
Growth rate estimate Source | Analyst x13 | Analyst x12 | Analyst x8 | Analyst x5 | Analyst x1 | East @ -5.1% | Is @ -3.31% | Is @ -2.05% | Is @ -1.17% | East @ -0.56% |
Present value (in millions of dollars) discounted at 8.3% | $27,500 | $24,000 | $20,000 | $14,300 | $16,000 | $14,000 | $12,500 | $11,300 | $10,300 | $9,500 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $159 billion
After calculating the present value of future cash flows over the initial 10-year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first stage. For a number of reasons, a very conservative growth rate is used which cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (0.9%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 8.3%.
Terminal value (TV)= FCF_{2031} × (1 + g) ÷ (r – g) = US$21 billion × (1 + 0.9%) ÷ (8.3%–0.9%) = US$286 billion
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= $286 billion ÷ (1 + 8.3%)^{ten}= $129 billion
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is $289 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of £20.9 in the UK, the company looks slightly undervalued at a 29% discount to the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in a different galaxy. Keep that in mind.
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 disagree with these results, try the math yourself and play around with the assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Shell 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 takes debt into account. In this calculation, we used 8.3%, which is based on a leveraged beta of 1.531. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Look forward:
Although important, the DCF calculation is just one of many factors you need to assess for a business. The DCF model is not a perfect stock valuation tool. Rather, it should be seen as a guide to “what assumptions must 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, output may be very different. Can we understand why the company is trading at a discount to its intrinsic value? For Shell, there are three fundamental elements to consider:
- Risks: For example, we discovered 1 warning sign for Shell which you should be aware of before investing here.
- Future earnings: How does SHEL’s growth rate compare to its peers and the broader market? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
- Other strong companies: Low debt, high returns on equity and good past performance are essential to a strong business. Why not explore our interactive list of stocks with strong trading fundamentals to see if there are any other companies you may not have considered!
PS. The Simply Wall St app performs an updated cash flow valuation for every stock on the LSE every day. If you want to find the calculation for other stocks, search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.