Through fundamental analysis, I will show that Chesapeake Energy Corporation (CHK) is currently "priced to perfection". Using the discounted cash flow (DCF) model, which is a favorite of Wall Street analyst, intrinsic value of CHK equity will be calculated. The saying "garbage in, garbage out" applies.
1. Growth Rate Estimation
First thing in finding a stocks intrinsic value is finding optimal growth rates. The growth rates needed are the excess growth rate and the long term growth rate.
The long term growth rate cannot be greater than the long term economic growth rate. Most analysts use between 3% and 5%. It is best to use conservative inputs when modeling, but you may use what is appropriate in your own opinion. This model is assuming a 3% long term growth rate.
For the excess growth rate, there are a few options. You may go to Yahoo Finance to receive the consensus 5 year estimated growth. For CHK, this rate is 11%. The next step is to use Excel functions. The trend and forecast function work well. The downfall with this method is using an improper sample size, or a trend that is non-linear. The latter is transparent, while the other may not be. In our sample size, dating back to 2001, it is clear that the trend is non-linear. The last excess growth rate to evaluate is from NYU professor Aswath Damodaran. His work is well respected in the finance industry. His estimates show that the Nat Gas industry has just about a 5.3% expected growth rate.
The closer your expected growth rates are to the actual (time permitting), the better your intrinsic value estimate will be. Since the quarter 1 2011 results are available, we have some help in choosing an optimal excess growth rate. Given that the quarter 1 revenue was only $1,612,000 (in thousands), even the 5.3% appears optimistic. (Keep in mind, it's only one quarter out of twenty; using a excess growth period of 5 years)
Here is the excess growth spreadsheet:
[Click all images to enlarge]
2. Free Cash Flow (FCF) Valuation
Now that we have projected growth rates, we can project future FCF of CHK. The method used in this analysis was published in the book "Streetsmart Guide To Valuing a Stock"
The equation of FCF: FCF= (NOP - Taxes - Net Investment) - Net change in working capital.
The spreadsheet appears as such:
3. WACC Calculation
Since future free cash flow is projected, discounting these values is essential. What this does is it gives us the present value. Theoretically, this is what an asset is worth. This is why it is called intrinsic value.
WACC= cost of debt (weight of debt) + cost of equity (weight of equity)
Here is the spreadsheet for such calculations:
4. Calculate Intrinsic Value
All that's left is simple algebra. The enterprise value = present value of the future cash flows + terminal value. Terminal value is the value that the firm accrues beyond the excess growth. Terminal value typically represents 60%-90% of the firm's value. In the final spreadsheet, you will see that it is quite a large portion of CHK's overall value.
Since we are looking for the value of the firm's equity, we must subtract the firm's debt. This gives us an equity value of $20,752,000 (in thousands).
Dividing $20,752,000 by 634,600 (outstanding shares), we get a per share value of $32.70.
Given that CHK is currently priced at $34.11 a share, it appears to be "priced to perfection".
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.