How far off is AGL Energy Limited (ASX:AGL) 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 todayâ€™s value. This is done using the Discounted Cash Flows (DCF) model. Donâ€™t get put off by the jargon, the math behind it is actually quite straightforward. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. Please also note that this article was written in October 2018 so be sure check out the updated calculation by following the link below.

See our latest analysis for AGL Energy

### 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 â€˜steady growthâ€™ period. 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$866.00 | A$744.50 | A$931.00 | A$987.01 | A$1.05k |

Source | Analyst x2 | Analyst x2 | Analyst x1 | Est @ 6.02% | Est @ 6.02% |

Present Value Discounted @ 8.55% | A$797.75 | A$631.78 | A$727.78 | A$710.76 | A$694.14 |

**Present Value of 5-year Cash Flow (PVCF)**= AU$3.6b

After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (2.8%). In the same way as with the 5-year â€˜growthâ€™ period, we discount this to todayâ€™s value at a cost of equity of 8.6%.

**Terminal Value (TV)** = FCF_{2022} Ã— (1 + g) Ã· (r â€“ g) = AU$1.0b Ã— (1 + 2.8%) Ã· (8.6% â€“ 2.8%) = AU$18.6b

**Present Value of Terminal Value (PVTV)** = TV / (1 + r)^{5} = AU$18.6b Ã· ( 1 + 8.6%)^{5} = AU$12.3b

The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is AU$15.9b. 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$24.25**. Relative to the current share price of A$18.65, the stock is about right, perhaps slightly undervalued at a 23% 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. You donâ€™t have to agree with my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at AGL 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 Iâ€™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:

Although the valuation of a company is important, it shouldnâ€™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 AGL, Iâ€™ve put together three fundamental factors you should look at:

**Financial Health**: Does AGL 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 AGLâ€™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 AGL? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. The Simply Wall St app conducts a discounted cash flow for every stock on the ASX every 6 hours. If you want to find the calculation for other stocks 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.*