Is Gulf Keystone Petroleum Limited (LON:GKP) Trading At A 31% Discount?
Key Insights
Using the 2 Stage Free Cash Flow to Equity, Gulf Keystone Petroleum fair value estimate is UK£1.46
Gulf Keystone Petroleum's UK£1.01 share price signals that it might be 31% undervalued
Our fair value estimate is 40% lower than Gulf Keystone Petroleum's analyst price target of US$2.43
Today we will run through one way of estimating the intrinsic value of Gulf Keystone Petroleum Limited (LON:GKP) by taking the expected future cash flows and discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
See our latest analysis for Gulf Keystone Petroleum
The Model
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) estimate
2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | 2033 | |
Levered FCF ($, Millions) | US$87.3m | US$107.0m | US$53.0m | US$30.2m | US$21.2m | US$16.9m | US$14.5m | US$13.2m | US$12.4m | US$11.9m |
Growth Rate Estimate Source | Analyst x4 | Analyst x2 | Analyst x1 | Est @ -43.08% | Est @ -29.74% | Est @ -20.41% | Est @ -13.87% | Est @ -9.30% | Est @ -6.09% | Est @ -3.85% |
Present Value ($, Millions) Discounted @ 7.1% | US$81.5 | US$93.3 | US$43.1 | US$22.9 | US$15.0 | US$11.2 | US$9.0 | US$7.6 | US$6.7 | US$6.0 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$296m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (1.4%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 7.1%.
Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$12m× (1 + 1.4%) ÷ (7.1%– 1.4%) = US$210m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$210m÷ ( 1 + 7.1%)10= US$106m
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$402m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£1.0, the company appears quite undervalued at a 31% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
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. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Gulf Keystone Petroleum 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 7.1%, which is based on a levered beta of 1.148. 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.
SWOT Analysis for Gulf Keystone Petroleum
Strength
Earnings growth over the past year exceeded its 5-year average.
Currently debt free.
Dividends are covered by earnings and cash flows.
Dividend is in the top 25% of dividend payers in the market.
Weakness
Earnings growth over the past year underperformed the Oil and Gas industry.
Opportunity
Good value based on P/E ratio and estimated fair value.
Threat
Annual earnings are forecast to decline for the next 3 years.
Moving On:
Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Gulf Keystone Petroleum, we've compiled three relevant aspects you should further research:
Risks: To that end, you should learn about the 3 warning signs we've spotted with Gulf Keystone Petroleum (including 1 which is a bit concerning) .
Future Earnings: How does GKP'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!
PS. Simply Wall St updates its DCF calculation for every British stock every day, so if you want to find the intrinsic value of any other stock just search here.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.
