In this article, we’ll estimate the intrinsic value of Magnolia Oil & Gas Corporation (NYSE: MGY) by taking expected future cash flows and discounting them to their present value. One way to do this is to use the Discounted Cash Flow (DCF) model. It may sound complicated, but it’s actually quite simple!
Keep in mind, however, that there are many ways to estimate the value of a business and that a DCF is just one method. If you still have burning questions about this type of valuation, take a look at the Simply Wall St.
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We use the 2-step growth model, which simply means that we take into account two stages of business growth. In the initial period, the business can have a higher growth rate, and the second stage is usually assumed to have a stable growth rate. To begin with, we need to estimate the next ten years of cash flow. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated 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 down more in the early years than in subsequent years.
In general, we assume that a dollar today is worth more than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today’s dollars:
10-year free cash flow (FCF) forecast
|Leverage FCF ($, Millions)||US $ 376.9 million||US $ 349.3 million||US $ 365.0 million||US $ 361.3 million||360.8 million US dollars||US $ 362.7 million||US $ 366.1 million||US $ 370.8 million||US $ 376.3 million||$ 382.4 million|
|Source of growth rate estimate||Analyst x5||Analyst x3||Analyst x1||Is @ -1.02%||East @ -0.12%||Is @ 0.51%||Est @ 0.96%||Est @ 1.27%||Is @ 1.48%||East @ 1.64%|
|Present value (in millions of dollars) discounted at 8.0%||US $ 349||US $ 299||US $ 289||US $ 265||US $ 245||$ 228||213 USD||US $ 200||US $ 188||177 USD|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 2.5 billion
It is now a matter of calculating the Terminal Value, which takes into account all future cash flows after this ten-year period. The Gordon growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.0%. We discount the terminal cash flows to their present value at a cost of equity of 8.0%.
Terminal value (TV)= FCF2031 Ã (1 + g) Ã· (r – g) = US $ 382 million Ã (1 + 2.0%) Ã· (8.0% – 2.0%) = US $ 6.4 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= US $ 6.4 billion Ã· (1 + 8.0%)ten= US $ 3.0 billion
Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is $ 5.4 billion. The last step is then to divide the equity value by the number of shares outstanding. Compared to the current share price of US $ 13.7, the company looks fairly good value with a 39% discount from the current share price. The assumptions in any calculation have a big impact on the valuation, so it’s best to take this as a rough estimate, not precise down to the last penny.
Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. Part of investing is coming up with your own assessment of a company’s future performance, so try the math yourself and check your own 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 Magnolia Oil & Gas 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 into account the debt. In this calculation, we used 8.0%, which is based on a leveraged beta of 1.281. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Valuation is only one side of the coin in terms of building your investment thesis, and it’s just one of the many factors you need to evaluate for a business. It is not possible to achieve a rock-solid valuation with a DCF model. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. Can we understand why the company trades at a discount to its intrinsic value? For Magnolia Oil & Gas, we’ve compiled three relevant things you should explore:
- Risks: Note that Magnolia Oil & Gas displays 2 warning signs in our investment analysis , and 1 of them should not be ignored …
- Future benefits: How does MGY’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth expectations chart.
- Other strong companies: 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 trading fundamentals to see if there are other companies you might not have considered!
PS. Simply Wall St updates its DCF calculation for every US stock every day, so if you want to find the intrinsic value of any other stock just search here.
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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in the mentioned stocks.
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