In this article, we will estimate the intrinsic value of Ampol Limited (ASX:ALD) by taking expected future cash flows and discounting them to the present value. On this occasion, we will use the Discounted Cash Flow (DCF) model. This may sound complicated, but it’s actually quite simple!

Remember though that there are many ways to estimate the value of a business and a DCF is just one method. For those who are passionate about stock analysis, the Simply Wall St analysis template here may interest you.

See our latest review for Ampol

The method

We use what is called a 2-stage model, which simply means that we have two different periods of company cash flow growth rates. Generally, the first stage is a higher growth phase and the second stage is a lower growth phase. To start, we need to estimate the cash flows for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported 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 more in early years than in later years.

A DCF is based on the idea that a dollar in the future is worth less 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) Forecast

(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = AU$5.6 billion

We now need to calculate the terminal value, which represents all future cash flows after this ten-year period. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 1.8%. We discount terminal cash flows to present value at a cost of equity of 7.7%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = AU$773 million × (1 + 1.8%) ÷ (7.7%–1.8%) = AU$13 billion

Present value of terminal value (PVTV)= TV / (1 + r)^ten= AU$13 billion÷ (1 + 7.7%)^ten= AU$6.4 billion

The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is A$12 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 AU$35.2, the company looks slightly undervalued at a 30% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.

The hypotheses

Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flows. If you disagree with these results, try the math yourself and play around with the assumptions. The DCF also does not take into account the possible cyclicality of an industry, nor the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Ampol 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 debt into account. In this calculation, we used 7.7%, which is based on a leveraged beta of 1.389. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

Next steps:

While a business valuation is important, it shouldn’t be the only metric to consider when researching a business. DCF models are not the be-all and end-all of investment valuation. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under/overvalued?” If a company grows at a different pace, or if its cost of equity or risk-free rate changes sharply, output may be very different. Can we understand why the company is trading at a discount to its intrinsic value? For Ampol, we’ve compiled three fundamentals you should consider:

1. Risks: For example, we discovered 1 warning sign for Ampol which you should be aware of before investing here.
2. Future earnings: How does ALD’s growth rate compare to its peers and the wider market? Dive deeper into the analyst consensus figure for the coming years 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 strong trading fundamentals to see if there are any other companies you may not have considered!

PS. Simply Wall St updates its DCF calculation for every Australian stock daily, so if you want to find the intrinsic value of any other stock, just search here.

Feedback on this article? Concerned about content? Get in touch with us directly. You can also email the editorial team (at) Simplywallst.com.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.