Is There An Opportunity With Pharos Energy plc's (LON:PHAR) 47% Undervaluation?
Key Insights
Using the 2 Stage Free Cash Flow to Equity, Pharos Energy fair value estimate is UK£0.43
Pharos Energy's UK£0.23 share price signals that it might be 47% undervalued
Our fair value estimate is 12% higher than Pharos Energy's analyst price target of US$0.38
How far off is Pharos Energy plc (LON:PHAR) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by projecting its future cash flows and then discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
Check out our latest analysis for Pharos Energy
Is Pharos Energy Fairly Valued?
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. To begin with, we have to get estimates of the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) forecast
2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | |
Levered FCF ($, Millions) | US$49.0m | US$57.9m | US$42.0m | US$34.0m | US$23.0m | US$18.5m | US$16.0m | US$14.5m | US$13.6m | US$13.1m |
Growth Rate Estimate Source | Analyst x2 | Analyst x3 | Analyst x2 | Analyst x1 | Analyst x1 | Est @ -19.76% | Est @ -13.49% | Est @ -9.10% | Est @ -6.02% | Est @ -3.87% |
Present Value ($, Millions) Discounted @ 12% | US$43.8 | US$46.3 | US$30.0 | US$21.8 | US$13.2 | US$9.4 | US$7.3 | US$5.9 | US$5.0 | US$4.3 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$187m
After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 1.2%. We discount the terminal cash flows to today's value at a cost of equity of 12%.
Terminal Value (TV)= FCF_{2032} × (1 + g) ÷ (r – g) = US$13m× (1 + 1.2%) ÷ (12%– 1.2%) = US$124m
Present Value of Terminal Value (PVTV)= TV / (1 + r)^{10}= US$124m÷ ( 1 + 12%)^{10}= US$41m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$228m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£0.2, the company appears quite undervalued at a 47% 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
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Pharos 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 12%, which is based on a levered beta of 1.529. 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 Pharos Energy
Strength
Debt is not viewed as a risk.
Dividends are covered by earnings and cash flows.
Weakness
Dividend is low compared to the top 25% of dividend payers in the Oil and Gas market.
Opportunity
Good value based on P/E ratio and estimated fair value.
Threat
Annual earnings are forecast to decline for the next 3 years.
Next Steps:
Although the valuation of a company is important, 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 example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Pharos Energy, we've put together three important elements you should explore:
Risks: As an example, we've found 2 warning signs for Pharos Energy (1 is significant!) that you need to consider before investing here.
Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for PHAR's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
Other High Quality Alternatives: Do you like a good all-rounder? 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 British stock every day, so if you want to find the intrinsic value of any other stock 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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