How far is EOG Resources, Inc. (NYSE: EOG) from its intrinsic value? Using the most recent financial data, we’ll examine whether the stock price is fair by estimating the company’s future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Patterns like these may seem beyond a layman’s comprehension, but they are fairly easy to follow.

We generally think of a business’s value as 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 its flaws. If you still have burning questions about this type of valuation, take a look at the Simply Wall St.

See our latest review for EOG resources

Step by step in the calculation

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.

In general, we assume that a dollar today is worth more than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at an estimate of the present value:

10-year free cash flow (FCF) forecast

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = 36 billion US dollars

After calculating the present value of future cash flows over the initial 10 year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first step. For a number of reasons, a very conservative growth rate is used which cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (2.0%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to their present value, using a cost of equity of 7.9%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = US $ 6.0B × (1 + 2.0%) ÷ (7.9% – 2.0%) = US $ 104B

Present value of terminal value (PVTV)= TV / (1 + r)^ten= US $ 104 billion ÷ (1 + 7.9%)^ten= 49 billion US dollars

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 US $ 85 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of US $ 83.9, the company appears to have very good value at a 42% discount from the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.

Important assumptions

Now the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. Part of investing is coming up with 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 consider 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 takes into account debt. In this calculation, we used 7.9%, which is based on a leveraged beta of 1.345. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

To move on :

While a business valuation is important, it shouldn’t be the only metric you look at when researching 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, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. Why is intrinsic value greater than the current share price? For EOG resources, you need to assess three additional factors:

1. Financial health: Does EOG have a healthy track record? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
2. Future benefits: How does EOG’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus number for years to come by interacting with our free analyst growth expectations chart.
3. Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what you might 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.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. 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 material. Simply Wall St has no position in any of the stocks mentioned.

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