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Is There An Opportunity With EOG Resources, Inc.'s (NYSE:EOG) 24% Undervaluation?

Simply Wall St

Today we will run through one way of estimating the intrinsic value of EOG Resources, Inc. (NYSE:EOG) by projecting its future cash flows and then discounting them to today's value. I will be using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

Check out our latest analysis for EOG Resources

The method

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. 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

2020

2021

2022

2023

2024

2025

2026

2027

2028

2029

Levered FCF ($, Millions)

US$1.36b

US$1.41b

US$3.43b

US$3.28b

US$3.74b

US$4.07b

US$4.34b

US$4.57b

US$4.76b

US$4.92b

Growth Rate Estimate Source

Analyst x8

Analyst x4

Analyst x2

Analyst x1

Analyst x1

Est @ 8.82%

Est @ 6.7%

Est @ 5.21%

Est @ 4.17%

Est @ 3.44%

Present Value ($, Millions) Discounted @ 7.3%

US$1.3k

US$1.2k

US$2.8k

US$2.5k

US$2.6k

US$2.7k

US$2.7k

US$2.6k

US$2.5k

US$2.4k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$23b

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 10-year government bond rate of 1.7%. We discount the terminal cash flows to today's value at a cost of equity of 7.3%.

Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = US$4.9b× (1 + 1.7%) ÷ 7.3%– 1.7%) = US$90b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$90b÷ ( 1 + 7.3%)10= US$45b

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$68b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$88.3, the company appears a touch undervalued at a 24% 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.

NYSE:EOG Intrinsic value, January 10th 2020
NYSE:EOG Intrinsic value, January 10th 2020

Important 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 EOG Resources 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 7.3%, which is based on a levered beta of 1.022. 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.

Next Steps:

Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. What is the reason for the share price to differ from the intrinsic value? For EOG Resources, I've compiled three relevant aspects you should look at:

  1. Financial Health: Does EOG 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.

  2. Future Earnings: How does EOG'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 High Quality Alternatives: Are there other high quality stocks you could be holding instead of EOG? 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 US stock every day, so if you want to find the intrinsic value of any other stock just search here.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.