Estimating The Intrinsic Value Of Devon Energy Corporation (NYSE:DVN)

Key Insights

• Devon Energy's estimated fair value is US$51.66 based on 2 Stage Free Cash Flow to Equity

• Devon Energy's US$47.26 share price indicates it is trading at similar levels as its fair value estimate

• The US$65.40 analyst price target for DVN is 27% more than our estimate of fair value

In this article we are going to estimate the intrinsic value of Devon Energy Corporation (NYSE:DVN) by projecting its future cash flows and then discounting them to today's value. Our analysis will employ 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 would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for Devon Energy

Step By Step Through The Calculation

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 start off with, we need to estimate 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, 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) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	US$3.55b	US$3.34b	US$3.27b	US$3.24b	US$2.75b	US$2.66b	US$2.62b	US$2.60b	US$2.61b	US$2.63b
Growth Rate Estimate Source	Analyst x4	Analyst x10	Analyst x8	Analyst x3	Analyst x1	Est @ -3.34%	Est @ -1.70%	Est @ -0.56%	Est @ 0.24%	Est @ 0.80%
Present Value ($, Millions) Discounted @ 9.6%	US$3.2k	US$2.8k	US$2.5k	US$2.2k	US$1.7k	US$1.5k	US$1.4k	US$1.3k	US$1.1k	US$1.1k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$19b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (2.1%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 9.6%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$2.6b× (1 + 2.1%) ÷ (9.6%– 2.1%) = US$36b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$36b÷ ( 1 + 9.6%)¹⁰= US$14b

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$33b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$47.3, the company appears about fair value at a 8.5% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own assumptions. 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 Devon 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 9.6%, which is based on a levered beta of 1.257. 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 Devon Energy

Strength

• Earnings growth over the past year exceeded its 5-year average.

• Debt is well covered by earnings and cashflows.

• Dividend is in the top 25% of dividend payers in the market.

Weakness

• Earnings growth over the past year underperformed the Oil and Gas industry.

Opportunity

• Good value based on P/E ratio and estimated fair value.

• Significant insider buying over the past 3 months.

Threat

• Dividends are not covered by cash flow.

• Annual earnings are forecast to decline for the next 3 years.

Moving On:

Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. 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. For Devon Energy, there are three fundamental factors you should explore:

1. Risks: For instance, we've identified 4 warning signs for Devon Energy (2 make us uncomfortable) you should be aware of.

2. Future Earnings: How does DVN's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.

3. 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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NYSE every day. If you want to find the calculation for other stocks 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.

Join A Paid User Research Session
You’ll receive a US$30 Amazon Gift card for 1 hour of your time while helping us build better investing tools for the individual investors like yourself. Sign up here