An Intrinsic Calculation For Southwestern Energy Company (NYSE:SWN) Suggests It's 50% Undervalued

Key Insights

• The projected fair value for Southwestern Energy is US$12.20 based on 2 Stage Free Cash Flow to Equity

• Current share price of US$6.10 suggests Southwestern Energy is potentially 50% undervalued

• Our fair value estimate is 59% higher than Southwestern Energy's analyst price target of US$7.68

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Southwestern Energy Company (NYSE:SWN) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

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 Southwestern Energy

The Method

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 'steady growth' period. To begin with, we have to get estimates of 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	US$644.0m	US$1.17b	US$1.25b	US$1.31b	US$1.36b	US$1.40b	US$1.45b	US$1.48b	US$1.52b	US$1.56b
Growth Rate Estimate Source	Analyst x8	Analyst x6	Analyst x1	Est @ 4.72%	Est @ 3.94%	Est @ 3.39%	Est @ 3.01%	Est @ 2.74%	Est @ 2.55%	Est @ 2.42%
Present Value ($, Millions) Discounted @ 11%	US$579	US$947	US$908	US$856	US$800	US$745	US$690	US$638	US$589	US$543

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$7.3b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 11%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$1.6b× (1 + 2.1%) ÷ (11%– 2.1%) = US$18b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$18b÷ ( 1 + 11%)¹⁰= US$6.1b

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$13b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$6.1, the company appears quite good value at a 50% 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.

dcf

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Southwestern 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 11%, which is based on a levered beta of 1.519. 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 Southwestern Energy

Strength

• Debt is well covered by earnings and cashflows.

Weakness

• No major weaknesses identified for SWN.

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 ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For Southwestern Energy, we've put together three additional elements you should further examine:

1. Risks: We feel that you should assess the 3 warning signs for Southwestern Energy (2 are a bit concerning!) we've flagged before making an investment in the company.

2. Future Earnings: How does SWN'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.

3. 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 NYSE 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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