An Intrinsic Calculation For Chesapeake Energy Corporation (NASDAQ:CHK) Suggests It's 39% Undervalued
Key Insights
Using the 2 Stage Free Cash Flow to Equity, Chesapeake Energy fair value estimate is US$134
Current share price of US$81.24 suggests Chesapeake Energy is potentially 39% undervalued
Our fair value estimate is 24% higher than Chesapeake Energy's analyst price target of US$108
Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Chesapeake Energy Corporation (NASDAQ:CHK) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. There's really not all that much to it, even though it might appear quite complex.
We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
View our latest analysis for Chesapeake Energy
Crunching The Numbers
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) forecast
2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | |
Levered FCF ($, Millions) | US$311.7m | US$779.4m | US$1.29b | US$1.41b | US$1.50b | US$1.58b | US$1.65b | US$1.71b | US$1.76b | US$1.81b |
Growth Rate Estimate Source | Analyst x7 | Analyst x7 | Analyst x5 | Analyst x2 | Est @ 6.49% | Est @ 5.18% | Est @ 4.26% | Est @ 3.61% | Est @ 3.16% | Est @ 2.85% |
Present Value ($, Millions) Discounted @ 9.6% | US$285 | US$649 | US$980 | US$979 | US$952 | US$914 | US$870 | US$823 | US$775 | US$727 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$8.0b
The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 (2.1%) 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 9.6%.
Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$1.8b× (1 + 2.1%) ÷ (9.6%– 2.1%) = US$25b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$25b÷ ( 1 + 9.6%)10= US$10.0b
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$18b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of US$81.2, the company appears quite undervalued at a 39% 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.
The 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. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Chesapeake Energy 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 9.6%, which is based on a levered beta of 1.254. 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 Chesapeake Energy
Strength
Debt is not viewed as a risk.
Dividends are covered by earnings and cash flows.
Dividend is in the top 25% of dividend payers in the market.
Weakness
Shareholders have been diluted in the past year.
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:
Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. 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. Can we work out why the company is trading at a discount to intrinsic value? For Chesapeake Energy, we've compiled three pertinent aspects you should explore:
Risks: Case in point, we've spotted 4 warning signs for Chesapeake Energy you should be aware of, and 2 of them are a bit concerning.
Future Earnings: How does CHK'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 Solid Businesses: 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 business fundamentals to see if there are other companies you may not have considered!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NASDAQGS every day. If you want to find the calculation for other stocks just search here.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.
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