Choosing the right financial tool to evaluate a company can be a daunting task, especially when different models are giving you drastically different conclusions. In the case of HollyFrontier Corporation’s (NYSE:HFC), my discounted cash flow (DCF) model tells me that HollyFrontier Corporation’s (NYSE:HFC) is undervalued by 8.71%; however, my relative valuation metrics tell me that HollyFrontier Corporation’s (NYSE:HFC) is overvalued by 59.57%. So, which model is more reliable and why?
Examining intrinsic valuation
Forecasting anything into the distant future is difficult and the same applies to forecasting free cash flows (FCFs) for businesses. This is why I’ve decided to use analyst FCF forecasts in my DCF to see what the consensus view is while also removing some subjectivity. If you’re unfamiliar with valuation, the assumption behind every DCF is that a firm’s true value is derived from the sum of all its future FCFs, which is why quality forecasts are important. To obtain the per share intrinsic value of HFC, we must first discount the sum of HFC’s future FCFs by 10%, which gives us an equity value of $US$11b, then 172.83k shares outstanding are divided through. This results in an intrinsic value of $62.51. Check out the source of my intrinsic value here.,
Before we accept this value and move on, let’s take a look at how reliable it is. Since it is generally impossible to forecast FCFs indefinitely, it is common for analysts to forecast for an explicit forecast horizon and then assume the company is mature by the end of that period and in a stable growth phase. HFC’s final year FCF growth rate of -17.91%, is too low. If this assumption held true, HFC would shrink to a point where it would cease to exist very soon, which is a highly unlikely outcome. Since these assumptions are far too extreme and unrealistic, one way of improving our DCF is to extend our forecast horizon by another few years until FCF growth moderates to a more sustainable rate. However, the trade-off is that there are less analyst forecasts the further in the future we go.
Examining relative valuation
The assumption behind relative valuation is that two companies with similar risk-return characteristics should have the same price since investors theoretically would be indifferent to purchasing either company. Unfortunately, the hardest part is finding companies that are similar enough to HFC to compare it against. As such, I’ve used the overall Oil and Gas industry as HFC’s proxy. The calculations for relative valuation are quite simple. By multiplying HFC’s earnings by the industry’s P/E ratio, we can obtain HFC’s fair value of $23.07, which tells us that it is overvalued. However, should we believe this result?
One quick way of finding out is to see if HFC shares a similar capital structure to the overall Oil and Gas industry we are comparing it to. This is an important check since the P/E ratio, which we are using for our relative valuation, can be distorted by different capital structures. At 36.71, HFC’s D/E ratio is significantly higher than the average firm in the Oil and Gas industry, which has a D/E ratio of 48.03%. In this case, rather than using a price multiple like P/E, we could resolve this issue by using an enterprise multiple like EV/EBITDA, which is immune from being influenced by differing capital structures.
Which Model Is Superior?
Both are somewhat weakened by assumptions we have used to fill in the gaps. Relative valuation is computationally simple but exposed to market irrationality, which undermines its usefulness. Conversely, intrinsic valuation is immune from these factors but heavily affected by human forecasting errors. Ultimately, investors should derive their final valuation based off both models. I encourage you to weight each model depending on your preferences to calculate a weighted average target price.
For HFC, I’ve put together three important factors you should further research:
- Financial Health: Does HFC 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 HFC’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 HFC? 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 NYSE 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 email@example.com.