Does Duke Energy Corporation’s (NYSE: DUK) July share price reflect its true value? Today we’re going to estimate the intrinsic value of the stock by taking the company’s future cash flow forecast and discounting it to today’s value. This will be done using the Discounted Cash Flow (DCF) model. Don’t be put off by the lingo, the math is actually pretty straightforward.
We generally believe that the value of a business is the present value of all the cash it will generate in the future. However, a DCF is only one evaluation measure among many, and it is not without its flaws. If you would like to know more about discounted cash flows, the rationale for this calculation can be read in detail in the Simply Wall St analysis model.
Check out our latest review for Duke Energy
The calculation
As Duke Energy operates in the electric utility industry, we have to calculate intrinsic value slightly differently. Instead of using free cash flow, which is difficult to estimate and often unreported by industry analysts, dividend payments per share (DPS) are used. Unless a company pays out the majority of its FCF as a dividend, this method will generally underestimate the value of the stock. We use Gordon’s growth model, which assumes that the dividend will grow in perpetuity at a rate that can be sustained. The dividend is expected to grow at an annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.0%. We then discount this figure to today’s value at a cost of equity of 5.8%. Compared to the current price of US $ 99.6, the company appears to be around fair value at the time of writing. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.
Value per share = Expected dividend per share / (Discount rate – Perpetual growth rate)
= US $ 4.1 / (5.8% – 2.0%)
= US $ 84.8
The hypotheses
The above calculation is very dependent on two assumptions. One is the discount rate and the other is cash flow. If you don’t agree with these results, try the calculation yourself and play with the assumptions. 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 Duke 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 debt into account. In this calculation, we used 5.8%, which is based on a leverage beta of 0.800. 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.
Next steps:
While important, calculating DCF ideally won’t be the only piece of analysis you’ll look at for a business. It is not possible to achieve a rock-solid valuation with a DCF model. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. For Duke Energy, we’ve put together three important things you should research further:
- Risks: For example, we have identified 6 warning signs for Duke Energy (1 is a bit rude) you should know about it.
- Future benefits: How does DUK’s growth rate compare to that of its peers and the wider market? Dig deeper into the analyst consensus number for years to come by interacting with our free analyst growth expectations chart.
- Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what else you might be missing!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for every NYSE share. If you want to find the calculation for other actions, do a search here.
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This Simply Wall St article is general in nature. 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 material. Simply Wall St has no position in any of the stocks mentioned.
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