Calculation of the fair value of ConocoPhillips (NYSE: COP)

In this article, we’ll estimate the intrinsic value of ConocoPhillips (NYSE: COP) by taking expected future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. It may sound complicated, but in fact it’s quite simple!

We generally believe that the value of a business is the present value of all the cash it will generate in the future. However, a DCF is only one evaluation measure among many, and it is not without flaws. If you want to know more about discounted cash flow, the rationale for this calculation can be read in detail in the Simply Wall St.

Check out our latest review for ConocoPhillips

What is the estimated valuation?

We are going to use a two-step DCF model which, as the name suggests, takes into account two growth stages. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “steady growth”. To begin with, we need to estimate the next ten years of cash flow. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous Free Cash Flow (FCF) from the last estimate or last published value. We assume that companies with decreasing free cash flow will slow their withdrawal rate, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect that growth tends to slow down more in the early years than in the following years.

A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we discount the value of those future cash flows to their estimated value in today’s dollars:

10-year free cash flow (FCF) estimate

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flow (PVCF) = 31 billion USD

Now we need to calculate the terminal value, which represents all future cash flows after that ten year period. Gordon’s growth formula is used to calculate the terminal value at a future annual growth rate equal to the five-year average of the 10-year government bond yield of 2.0%. We discount the terminal cash flows to their present value at a cost of equity of 9.0%.

Terminal value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = $ 4.7 billion × (1 + 2.0%) ÷ (9.0% – 2.0%) = $ 68 billion

Present value of terminal value (PVTV)= TV / (1 + r)^ten= 68 billion USD ÷ (1 + 9.0%)^ten= 29 billion USD

The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total value of equity, which in this case is US $ 60 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of US $ 48.4, the company appears to be around fair value at the time of writing. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.

The hypotheses

Now the most important data for a discounted cash flow is the discount rate and, of course, the actual cash flow. Part of investing is making your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view ConocoPhillips 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 takes into account debt. In this calculation, we used 9.0%, which is based on a leveraged beta of 1.335. Beta is a measure of the volatility of a stock, relative 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.

Move on:

While important, the DCF calculation shouldn’t be the only metric you look at when researching a business. DCF models are not the ultimate investment valuation solution. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. For ConocoPhillips, we have compiled three relevant aspects that you should explore:

1. Risks: You should be aware of the 4 warning signs for ConocoPhillips we found out before considering an investment in the business.
2. Future income: How does COP’s growth rate compare to its peers and to the market in general? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth forecast chart.
3. Other strong companies: Low debt, high returns on equity, and good past performance are essential to a strong business. Why not explore our interactive list of stocks with solid trading fundamentals to see if there are other companies you may not have considered!

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.

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This Simply Wall St article is general in nature. It is not a recommendation to buy or sell any stock, and does not take into account your goals or your financial situation. We aim to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative information. Simply Wall St has no position in any of the stocks mentioned.
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