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By Ahmed Ishtiaq

Chesapeake Energy (NYSE:CHK) has been through a lot of controversies due to poor corporate governance and some dodgy decisions. In addition, a slump in the natural gas prices brought the second-biggest gas producer considerable trouble. However, significant changes at the board level and recovery in natural gas prices have allowed the stock to regain some of the lost value. A colder winter had a positive impact on the demand of natural gas the company was able to regain some of the faith shown by investors in the past.

As of the time of writing this article, Chesapeake stock was trading at around $19.75, with a 52-week range of $13.32 - $26.09. It has a market cap of about $13.1 billion. The trailing twelve-month P/E ratio of 6.01 is below the forward P/E ratio of 14.0. P/B, P/S, and P/CF ratios stand at 1.1, 5.64, and 3.2, respectively. The operating margin is -14.9% while the net profit margin is -6.7%. The company has a high debt load, with a debt/equity ratio of 1.3.

Chesapeake has a 4-star rating from Morningstar. Out of 10 analysts covering the stock, four have a buy recommendation and two have sell recommendations. On the other hand, most of the analysts have market outperform rating, and four analysts have recently upgraded the stock. Average five-year annualized growth forecast estimate is 8.7%.

We can estimate Chesapeake fair value using discounted earnings plus equity model as follows.

Discounted Earnings plus Equity Model

This model is primarily used for estimating the returns from long-term projects. It is also frequently used to price fair-valued IPOs. The methodology is based on discounting the present value of the future earnings to the current period:

V = E0 + E1 /(1+r) + E2 /(1+r)2 + E3/(1+r)3 + E4/(1+r)4 + E5/(1+r)5+ Disposal Value

V = E0 + E0 (1+g)/(1+r) + E0(1+g)2/(1+r)2 + … + E0(1+g)5/(1+r)5 + E0(1+g)5/[r(1+r)5]

The earnings after the last period act as a perpetuity that creates regular earnings:

Disposal Value = D = E0(1+g)5/[r(1+r)5] = E5 / r

While this formula might look scary for many of us, it easily calculates the fair value of a stock. All we need is the current-period earnings, earnings growth estimate, and the discount rate. To be as objective as possible, I use Morningstar data for my estimates. You can set these parameters as you wish, according to your own diligence.

Valuation

Historically, the average return of the DJI has been around 11% (including dividends). Therefore, I will use 11% as my discount rate.

In order to smooth the results, I will also take the average of ttm EPS along with the mean EPS estimate for the next year. The average EPS for Chesapeake is $1.45.

While analysts tend to impose subjective opinions on their estimates, the average analyst estimate is a good starting point. Average five-year growth forecast is 8.7%. Book value per share is $3.50.

Fair Value Estimator

V0

E0

$1.45

V1

E0 (1+g)/(1+r)

$1.44

V2

E0((1+g)/(1+r))2

$1.42

V3

E0((1+g)/(1+r))3

$1.41

V4

E0((1+g)/(1+r))4

$1.40

V5

E0((1+g)/(1+r))5

$1.39

D

E0(1+g)5/[r(1+r)5]

$12.60

BV

Equals

$3.50

Fair Value Range

Lower Boundary

$21.11

Upper Boundary

$24.61

Potential

24.59%

(You can download FED+ Fair Value Estimator, here.)

I decided to add the book value per share so that we can distinguish between a low-debt and debt-loaded company. The lower boundary does not include the book value. According to my 5-year discounted-earnings-plus-book-value model, the fair-value range for Chesapeake is between $21.11 and $24.61 per share. At a price of about $19.75, Chesapeake is trading below the lower boundary of its fair value range. The stock still has up to 25% upside potential to reach its fair value maximum.

Summary

We have seen a recovery in stock price due to increased demand of natural gas in the past two months. Furthermore, the company has modified its business model, and currently it is focusing on liquids more than natural gas. As a result, Chesapeake is getting some balance in its assets portfolio. There are also opportunities for the company to export natural gas. I have long remained an optimist about the company and in my previous articles, I have mentioned that the stock will rebound. I see substantial upside potential in Chesapeake and patient investors will get healthy profits.

Source: Chesapeake Has Substantial Upside Potential