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Phillips 66's (NYSE:PSX) Intrinsic Value Is Potentially 85% Above Its Share Price

Key Insights

  • The projected fair value for Phillips 66 is US$245 based on 2 Stage Free Cash Flow to Equity

  • Phillips 66 is estimated to be 46% undervalued based on current share price of US$132

  • Analyst price target for PSX is US$153 which is 37% below our fair value estimate

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. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

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 Phillips 66

What's The Estimated Valuation?

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

2025

2026

2027

2028

2029

2030

2031

2032

2033

2034

Levered FCF ($, Millions)

US$5.34b

US$5.47b

US$5.59b

US$5.72b

US$5.86b

US$6.00b

US$6.15b

US$6.30b

US$6.45b

US$6.61b

Growth Rate Estimate Source

Analyst x4

Analyst x2

Est @ 2.28%

Est @ 2.34%

Est @ 2.39%

Est @ 2.42%

Est @ 2.45%

Est @ 2.46%

Est @ 2.47%

Est @ 2.48%

Present Value ($, Millions) Discounted @ 7.7%

US$5.0k

US$4.7k

US$4.5k

US$4.3k

US$4.0k

US$3.8k

US$3.7k

US$3.5k

US$3.3k

US$3.2k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$40b

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 (2.5%) 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 7.7%.

Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = US$6.6b× (1 + 2.5%) ÷ (7.7%– 2.5%) = US$131b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$131b÷ ( 1 + 7.7%)10= US$63b

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$102b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of US$132, the company appears quite good value at a 46% 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
dcf

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 7.7%, which is based on a levered beta of 1.256. 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:

Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. 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. Why is the intrinsic value higher than the current share price? For Phillips 66, we've compiled three essential elements you should further examine:

  1. Risks: Be aware that Phillips 66 is showing 2 warning signs in our investment analysis , you should know about...

  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. 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.