Are Investors Undervaluing Phillips 66 (NYSE:PSX) By 44%?

Simply Wall St · 10/17 13:16

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, Phillips 66 fair value estimate is US$237
  • Phillips 66's US$132 share price signals that it might be 44% undervalued
  • Our fair value estimate is 66% higher than Phillips 66's analyst price target of US$143

In this article we are going to estimate the intrinsic value of Phillips 66 (NYSE:PSX) by taking the forecast future cash flows of the company and discounting them back to today's value. This will be done using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

View our latest analysis for Phillips 66

The Method

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

2025 2026 2027 2028 2029 2030 2031 2032 2033 2034
Levered FCF ($, Millions) US$4.81b US$5.07b US$5.28b US$5.47b US$5.65b US$5.82b US$5.99b US$6.15b US$6.32b US$6.49b
Growth Rate Estimate Source Analyst x4 Analyst x3 Est @ 4.13% Est @ 3.64% Est @ 3.30% Est @ 3.06% Est @ 2.89% Est @ 2.77% Est @ 2.69% Est @ 2.63%
Present Value ($, Millions) Discounted @ 7.7% US$4.5k US$4.4k US$4.2k US$4.1k US$3.9k US$3.7k US$3.6k US$3.4k US$3.2k US$3.1k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$38b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 2.5%. We discount the terminal cash flows to today's value at a cost of equity of 7.7%.

Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = US$6.5b× (1 + 2.5%) ÷ (7.7%– 2.5%) = US$128b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$128b÷ ( 1 + 7.7%)10= US$61b

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$99b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$132, the company appears quite good value at a 44% 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
NYSE:PSX Discounted Cash Flow October 17th 2024

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 7.7%, which is based on a levered beta of 1.260. 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.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For Phillips 66, we've put together three additional elements you should assess:

  1. Risks: We feel that you should assess the 2 warning signs for Phillips 66 we've flagged before making an investment in the company.
  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 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.