Advertisement
New Zealand markets open in 4 hours 41 minutes
  • NZX 50

    12,329.44
    +37.41 (+0.30%)
     
  • NZD/USD

    0.6064
    -0.0019 (-0.32%)
     
  • ALL ORDS

    8,272.70
    -30.80 (-0.37%)
     
  • OIL

    83.27
    +0.42 (+0.51%)
     
  • GOLD

    2,457.00
    -2.90 (-0.12%)
     

Are Investors Undervaluing Phillips 66 (NYSE:PSX) By 40%?

Key Insights

  • Phillips 66's estimated fair value is US$230 based on 2 Stage Free Cash Flow to Equity

  • Phillips 66's US$137 share price signals that it might be 40% undervalued

  • Our fair value estimate is 42% higher than Phillips 66's analyst price target of US$162

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Phillips 66 (NYSE:PSX) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. It may sound complicated, but actually it is quite simple!

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.

ADVERTISEMENT

View our latest analysis for Phillips 66

The Method

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To begin with, we have to get estimates of 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

2024

2025

2026

2027

2028

2029

2030

2031

2032

2033

Levered FCF ($, Millions)

US$4.82b

US$5.65b

US$5.91b

US$6.12b

US$6.32b

US$6.51b

US$6.69b

US$6.87b

US$7.05b

US$7.22b

Growth Rate Estimate Source

Analyst x4

Analyst x4

Analyst x3

Est @ 3.60%

Est @ 3.24%

Est @ 2.98%

Est @ 2.80%

Est @ 2.67%

Est @ 2.59%

Est @ 2.52%

Present Value ($, Millions) Discounted @ 8.3%

US$4.5k

US$4.8k

US$4.7k

US$4.5k

US$4.2k

US$4.0k

US$3.8k

US$3.6k

US$3.4k

US$3.3k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$41b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.4%. We discount the terminal cash flows to today's value at a cost of equity of 8.3%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$7.2b× (1 + 2.4%) ÷ (8.3%– 2.4%) = US$125b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$125b÷ ( 1 + 8.3%)10= US$57b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$97b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of US$137, the company appears quite undervalued at a 40% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf
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 Phillips 66 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 8.3%, which is based on a levered beta of 1.282. 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 Phillips 66

Strength

  • Debt is well covered by earnings and cashflows.

  • Dividends are covered by earnings and cash flows.

Weakness

  • Earnings declined over the past year.

  • Dividend is low compared to the top 25% of dividend payers in the Oil and Gas market.

Opportunity

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

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

Threat

  • Annual earnings are forecast to grow slower than the American market.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. Can we work out why the company is trading at a discount to intrinsic value? For Phillips 66, we've compiled three important elements you should consider:

  1. Risks: To that end, you should be aware of the 2 warning signs we've spotted with Phillips 66 .

  2. Future Earnings: How does PSX'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 Solid Businesses: 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 business fundamentals to see if there are other companies you may not have considered!

PS. Simply Wall St updates its DCF calculation for every American stock every day, so if you want to find the intrinsic value of any other stock 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com