Unlike fixed income, where one merely needs to see where in the risk spectrum a company falls, investing in equities involves extensive analysis of a company’s balance sheet, growth opportunity, and competitive position in the market.
Most investors can access a Discounted Cash Flow (DCF) analysis of ExxonMobil (XOM) when evaluating its investment prospects.
Projecting future cash flows and discounting them back to the present value can be a sound approach to determining the intrinsic worth of a firm and is precisely the model on which DCF is based.
In this post, I will break apart those DCF operations, illustrate the reason for assessing XOM, and demonstrate how you can utilize the DCF to gain insight into the business’s future investment options.
This approach is particularly relevant for investors who want to make informed decisions regarding ExxonMobil’s financial status and future projections.
Discounted Cash Flow, or DCF:
There is so much to learn about what DCF is before getting into its use for evaluating XOM. DCF is a valuation method approach that seeks to value an asset based on the cash flows it is expected to generate.
However, DCF relies on the concept of the time value of money — the fundamental premise that a dollar today is better than a dollar tomorrow.
Thus, future cash flows require an adjustment to recognize their value in today’s terms.
The DCF form establishes a company’s future cash flow for a period and uses a discount rate to calculate the cash present value.
This method results in an estimated intrinsic value of the company or investment.
If the calculated intrinsic value exceeds that of the current market price, the investment will be classified as underpriced and, therefore, a buying opportunity.
Conversely, the investment can be overpriced if the underlying value is lower than the price at which the market prices it.
Why Evaluating XOM Using DCF
As one of the world’s largest publicly traded oil and gas companies, ExxonMobil’s performance is influenced by a wide range of factors, including global oil prices, energy demand, regulatory changes, and technological innovation.
Understanding the impact of these factors on ExxonMobil’s cash flows and prospects for future growth is critical for making sound investment decisions.
Instead of relying solely on ExxonMobil’s market price, the DCF method enables you to assess its inherent value derived from its projected future earnings.
It allows you to more accurately determine if the current stock price of XOM is aligned with their long-term outlook.
For example, XOM may be volatile temporarily based on market conditions.
However, a DCF study will allow you to look beyond this and assess its long-term value based on fundamentals.
Important Parts of DCF Valuation for XOM
To perform a DCF valuation for XOM, you need to gather data on several key components:
- Revenue and Earnings Projections: The first step in any DCF analysis is to forecast the company’s future cash flows. This involves projecting revenues and expenses for the upcoming years. For example XOM revenues and expenses can be projected by analyzing its historical performance, current market trends, and potential future growth drivers.
- Free Cash Flow (FCF): A corporation’s free cash flow is the cash generated following capital expenditures required to maintain or grow its operations. Since FCF measures the cash available to creditors and shareholders, it is the most crucial statistic in DCF valuation. Regarding XOM, you should examine the company’s current free cash flow and prospective changes.
- Discount Rate: The time value of money is accounted for via the discount rate. It shows the predicted return on an alternative investment with the same risk as the risk related to the investment. The weighted average cost of capital (WACC) of the company helps one to project the discount rate by aggregating the borrowed capital and equity costs.
- Terminal Value: DCF values depend on a limited period of forecasting cash flows. Hence, it is crucial to consider the company’s value outside of the forecast horizon. Based on its predicted future cash flows, the terminal value—the company’s estimated worth after the forecast period—is. The perpetuity growth approach allows one to determine this by presuming a constant growth rate for the company’s cash flows beyond the projected period.
- Discounted Cash Flow Calculation: Once you have all the facts, you need to find the current value of the company’s future cash flows. This entails running the discount rate on every predicted cash flow, including the terminal value, to find its present value. These present values, taken together, provide ExxonMobil’s total inherent value.
How to Apply DCF Valuation to XOM
Now that we have covered the main building blocks, let’s go through the XOM DCF valuation.
This entails forecasting XOM’s future cash flows, selecting an appropriate discount rate, and calculating the present value of these cash flows.
For example, the future cash flows of XOM can be modeled based on its previous business performance, market background, and potential future growth catalysts.
Estimate Revenue and Earnings Projections
Reviewing ExxonMobil’s past financials first will allow you to think about how its sales growth, profit margins, and any other factors will impact its future performance.
You need to think about macroeconomic factors, like oil prices, as well as company-specific factors, like spending on renewable-energy projects or cost-cutting initiatives.
After looking at these factors, you might estimate ExxonMobil’s income and revenues for the next five to ten years.
Let’s assume, for example, that you would like ExxonMobil’s income to grow at a 5 percent annual rate over the next five years based on flat oil prices and increasing demand for natural gas.
Calculate Free Cash Flow (FCF)
Then, figure out ExxonMobil’s expected period’s free cash flow.
Operating cash flow less capital expenditures yields free cash flow.
ExxonMobil’s financial statements have these figures there.
The following stage can begin once you have computed the FCF for every year in your projection.
Estimate the Discount Rate
A fundamental part of the DCF method is that the discount rate adjusts future cash flows for money’s time value and risk.
Now, for a corporation such as XOM, a typical discount rate will be based upon the following weighted average cost of capital (WACC).
To project this, calculate the cost of debt and cost of equity—weighted by the company’s capital structure.
One can estimate the cost of equity using the Capital Asset Pricing Model (CAPM) which takes into consideration the risk-free rate plus the equity market premium multiplied by the firm’s beta — a measure of its stock price volatility relative to the market.
Looking at ExxonMobil’s current borrowing numbers helps one forecast the cost of its debt.
Calculate the Present Value of Cash Flows
Applying the discount rate will help you to determine the present value of the free cash flow for every year once you have all the elements.
To determine ExxonMobil’s overall present value after that, add the terminal value’s present value.
Dividing the entire present value by the outstanding number of shares will provide the intrinsic value per share at last.
Should the intrinsic value per share be above XOM’s current market price, it could suggest an undervaluation of the company, thereby attractiveness of the investment.
XOM would be overpriced, on the other hand, if the intrinsic value per share is less than the market price.
Essential Factors Regarding DCF Use for XOM
While the DCFattle line is a valuable tool to evaluate the investment potential of XOM, it is essential to note that this measure relies on several assumptions.
A small change in the discount rate, capital expenditures, or estimated income growth rates can result in a drastically different final valuation.
A sensitivity analysis is crucial to understand how various assumptions affect the calculated intrinsic value.
In addition, DCF ignores market sentiment or temporary stock price fluctuations, which can be influenced by factors unrelated to the business.
Thus, to assess ExxonMobil’s potential value as an investor, DCF must be considered along with alternative valuation methods such as P/E ratios.
End
Examining ExxonMobil’s future cash flows and potential for expansion allows XOM to be analyzed using discounted cash flow (DCF) analysis to determine investment worth.
You can refine those initial figures to estimate income, free cash flow, and the appropriate discount rate you expect to apply to determine ExxonMobil’s intrinsic worth and how it stacks against its current market pricing.
This approach allows investors to construct a more informed projection of the company’s long-term potential, leading to well-founded and confident investment decisions.
Whether you are a seasoned pro or just getting started, employing DCF to evaluate XOM will aid you in understanding what value is for this energy giant and help with investment decisions.
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