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Deciding if you should use a relative valuation model over an intrinsic valuation model can be a difficult choice for many investors. In the case of LyondellBasell Industries N.V.’s (NYSE:LYB), my discounted cash flow (DCF) model tells me that LyondellBasell Industries N.V.’s (NYSE:LYB) is overvalued by 9.49%; however, my relative valuation metrics tell me that LyondellBasell Industries N.V.’s (NYSE:LYB) is undervalued by 175.68%. So, which valuation methodology should I listen to and why?
Deep-dive into intrinsic valuation
The DCF model follows the principle that a firm’s “true” value today is equal to the sum of all its the future free cash flows (FCF) it will make in the future (to infinity). Since the hardest part of constructing a DCF is forecasting this, I’ve decided to use the average expected FCF forecasted by broker analysts in my model. To obtain the per share intrinsic value of LYB, we must first discount the sum of LYB’s future FCFs by 11%, which gives us an equity value of $US$30b, then 376.00k shares outstanding are divided through. This results in an intrinsic value of $79.98. 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. LYB’s final year FCF growth rate of -15.42%, is too low. If this assumption held true, LYB would shrink to a point where it would cease to exist very soon, which is a highly unlikely outcome. To improve our DCF analysis, we could extend the terminal year until FCF growth moderates to a more sustainable level around 1% to 5%. However, the trade-off is that there are less analyst forecasts the further in the future we go.
Examining relative valuation
The basic principle of relative valuation is that two companies with near identical characteristics should be priced similarly. But a big issue here is actually finding companies that are similar to LYB, so I’ve used the Chemicals industry as a proxy. Obtaining the fair value of LYB through relative valuation is quite straightforward. We simply multiply LYB’s earnings by the industry’s P/E ratio, which gives us a share price of $241.41 that implies LYB is currently undervalued. However, is this conclusion robust enough for us to use?
To check the robustness of our relative valuation, let’s take a look at if LYB shares a similar capital structure with the overall Chemicals industry. 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 78.31, LYB’s D/E ratio is significantly higher than the average firm in the Chemicals industry, which has a D/E ratio of 109.98%. 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 Should I Care About?
Neither model is perfect despite the robust financial theory behind them. 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 LYB, I’ve compiled three pertinent aspects you should further examine:
- Financial Health: Does LYB 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 LYB’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 LYB? 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 does a DCF calculation for every US stock every 6 hours, so if you want to find the intrinsic value of any other stock 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 firstname.lastname@example.org.