Is there an opportunity with the 40% undervaluation of Kosmos Energy Ltd. (NYSE: KOS)?

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In this article, we will estimate the intrinsic value of Kosmos Energy Ltd. (NYSE: KOS) by projecting its future cash flows and then discounting them to present value. Our analysis will use the discounted cash flow (DCF) model. There really isn’t much to do, although it might seem quite complex.

Remember, however, that there are many ways to estimate the value of a business, and a DCF is just one method. If you would like to know more about discounted cash flow, the rationale for this calculation can be read in detail in the Simply Wall St.

Check out our latest analysis for Kosmos Energy

Step by step in the calculation

We are going to use a two-step DCF model, which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “steady growth”. To begin with, we need to get cash flow estimates for the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated value. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent years.

Generally, we assume that a dollar today is worth more 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) forecast

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Leverage FCF ($, Millions) 178.6 million US dollars 84.3 million US dollars US $ 313.0 million US $ 259.0 million US $ 229.0 million 211.8 million US dollars 201.9 million US dollars US $ 196.5 million US $ 193.9 million US $ 193.3 million
Source of estimated growth rate Analyst x3 Analyst x3 Analyst x2 Analyst x1 Is @ -11.58% Is @ -7.52% Is @ -4.67% East @ -2.68% Is @ -1.29% East @ -0.32%
Present value (in millions of dollars) discounted at 11% US $ 161 $ 68.7 US $ 231 $ 172 US $ 138 115 USD US $ 99.0 US $ 87.0 $ 77.6 $ 69.8

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 1.2 billion

It is now a matter of calculating the Terminal Value, which takes into account all future cash flows after this ten-year period. The Gordon growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.0%. We discount terminal cash flows to their present value at a cost of equity of 11%.

Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US $ 193 million × (1 + 2.0%) ÷ (11% to 2.0%) = US $ 2.3 billion

Present value of terminal value (PVTV)= TV / (1 + r)ten= US $ 2.3 billion ÷ (1 + 11%)ten= US $ 813 million

The total value is the sum of the cash flows for the next ten years plus the final present value, which gives the total value of equity, which in this case is $ 2.0 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of US $ 3.0, the company appears to be quite undervalued with a 40% discount from the current share price. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.

NYSE: KOS Discounted Cash Flow October 1, 2021

The hypotheses

We draw your attention to the fact that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play with them. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view Kosmos 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 takes into account debt. In this calculation, we used 11%, which is based on a leveraged beta of 2,000. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

To move on :

Valuation is only one side of the coin in terms of building your investment thesis, and ideally, it won’t be the only piece of analysis you look at for a business. The DCF model is not a perfect equity valuation tool. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. Can we understand why the company trades at a discount to its intrinsic value? For Kosmos Energy, we have compiled three important factors that you should explore:

  1. Risks: Consider, for example, the ever-present specter of investment risk. We have identified 1 warning sign with Kosmos Energy, and understanding this should be part of your investment process.
  2. Future benefits: How does KOS’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth expectations chart.
  3. Other strong companies: 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 trading fundamentals to see if there are other companies you might not have considered!

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

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in the mentioned stocks.

Do you have any feedback on this item? Are you worried about the content? Get in touch with us directly. You can also send an email to the editorial team (at) simplywallst.com.

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