Peabody Energy Corporation (NYSE:BTU) is a company that has sparked interest among investors. To determine whether the stock is fairly priced, it is crucial to assess its intrinsic value. This can be achieved using the Dividend Discount Model (DCF), which calculates the present value of expected future cash flows. Let’s explore how this model can shed light on the fair value of Peabody Energy.
Crunching the Numbers
When valuing Peabody Energy, we need to employ a slightly different approach due to its status as an oil and gas company. Analysts often find it challenging to estimate and report free cash flows (FCF) accurately. Consequently, in this situation, the Dividends Per Share (DPS) method is utilized instead. However, if a company does not distribute a substantial majority of its FCF as dividends, this method typically underestimates the stock’s value.
For the valuation, we make use of the Gordon Growth Model, which assumes that the dividends will grow at a sustainable rate into perpetuity. In the case of Peabody Energy, the expected dividend growth rate is equal to the 5-year average of the 10-year government bond yield, which stands at 2.2%. To calculate the present value, we discount this figure using a cost of equity rate of 6.2%.
Based on this analysis, Peabody Energy appears to be trading about fair value, with a slight 11% discount to the current share price of $23.79. The DCF model, however, relies heavily on its assumptions, and therefore, this estimate should be considered as a rough approximation rather than an exact value.
Value Per Share = Expected Dividend Per Share / (Discount Rate – Perpetual Growth Rate) = $1.10 / (6.2% – 2.2%) = $26.83
The Assumptions
The accuracy of a DCF model depends on the discount rate and the actual cash flows, both of which are essential inputs. Nevertheless, it is advisable to redo these calculations independently to gain a better understanding. Additionally, the DCF model does not account for industry cyclicality or a company’s future capital requirements, limiting its comprehensive assessment of a company’s potential performance.
As potential shareholders of Peabody Energy, we use the cost of equity as the discount rate rather than the cost of capital, which considers debt. A rate of 6.2% is adopted based on a levered beta of 0.8. Beta measures a stock’s volatility compared to the overall market. The beta used in this calculation is derived from the average beta of comparable companies worldwide, with a range between 0.8 and 2.0.
SWOT Analysis for Peabody Energy
Peabody Energy exhibits certain strengths and weaknesses that should be considered. The company’s earnings growth has surpassed the industry average and its debt is not viewed as a risk. Furthermore, dividends are covered by earnings and cash flows. However, the dividend payout is comparatively low in relation to the top 25% of dividend payers in the Oil and Gas market. On the opportunity side, Peabody Energy shows potential as a good value based on its P/E ratio and estimated fair value. Nonetheless, there is a threat to the company as annual earnings are projected to decline over the next three years.
Next Steps
It is important to note that valuation is just one component of building an investment thesis and should not be the sole factor. Different scenarios and assumptions can be applied to evaluate a company’s valuation comprehensively. In the case of Peabody Energy, it is recommended to consider the risks, future earnings growth rate, and analyze other solid businesses within the industry.
Valuation is a complex process, but Simply Wall St provides a daily updated DCF calculation for American stocks. For a comprehensive analysis that includes fair value estimates, risks, dividends, insider transactions, and financial health, check out Simply Wall St’s free analysis of Peabody Energy.
Sources: Simply Wall St
