In this article, we’ll estimate the intrinsic value of Callon Petroleum Company (NYSE: CPE) by taking expected future cash flows and discounting them to their present value. One way to do this is to use the Discounted Cash Flow (DCF) model. There really isn’t much to do, although it might seem quite complex.

We draw your attention to the fact that there are many ways to assess a business and, like DCF, each technique has advantages and disadvantages in certain scenarios. For those who are passionate about equity analysis, the Simply Wall St analysis template here may be something of interest to you.

Check out our latest analysis for Callon Petroleum

The model

We use the 2-step growth model, which simply means that we take into account two stages of business growth. In the initial period, the business can have a higher growth rate, and the second stage is usually assumed to have a stable growth rate. 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 stated value. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent 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. hui:

10-year Free Cash Flow (FCF) estimate

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 1.6 billion

The second stage is also known as terminal value, this is the cash flow of the business after the first stage. The Gordon growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.0%. We discount terminal cash flows to their present value at a cost of equity of 11%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = US $ 264 million × (1 + 2.0%) ÷ (11% to 2.0%) = US $ 2.9 billion

Present value of terminal value (PVTV)= TV / (1 + r)^ten= US $ 2.9b ÷ (1 + 11%)^ten= US $ 968 million

The total value is the sum of the cash flows for the next ten years plus the final present value, which gives the total value of equity, which in this case is $ 2.6 billion. The last step is then to divide the equity value by the number of shares outstanding. From the current share price of US $ 41.4, the company appears to be slightly undervalued with a 26% discount from the current share price. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.

The hypotheses

The above calculation is very dependent on two assumptions. One is the discount rate and the other is cash flow. If you don’t agree with these results, try the calculation yourself and play with the 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 full picture of a company’s potential performance. Since we consider Callon Petroleum 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 11%, which is based on a leveraged beta of 2,000. 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 from globally comparable companies, with a limit imposed between 0.8 and 2.0, which is a reasonable range for a stable business.

Looking forward:

While a business valuation is important, ideally it won’t be the only analysis you review for a business. It is not possible to achieve a rock-solid valuation with a DCF model. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. Why is intrinsic value greater than the current share price? For Callon Petroleum, we have put together three fundamental aspects that you should investigate further:

1. Risks: For example, we have identified 2 warning signs for Callon Petroleum that you need to be aware of.
2. Future benefits: How does CPE’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth expectations chart.
3. Other strong companies: 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 trading fundamentals to see if there are other companies you might not have considered!

PS. The Simply Wall St app performs a daily discounted cash flow assessment for every NYSE share. If you want to find the calculation for other actions, just search here.

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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is 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 documents. Simply Wall St has no position in any of the stocks mentioned.
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