Is Ithaca Energy plc (LON:ITH) Trading At A 49% Discount?

Key Insights

• Ithaca Energy's estimated fair value is UK£3.39 based on Dividend Discount Model

• Ithaca Energy is estimated to be 49% undervalued based on current share price of UK£1.73

• The US$1.86 analyst price target for ITH is 45% less than our estimate of fair value

Does the September share price for Ithaca Energy plc (LON:ITH) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to their present value. Our analysis will employ the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Ithaca Energy

The Calculation

As Ithaca Energy operates in the oil and gas sector, we need to calculate the intrinsic value slightly differently. In this approach dividends per share (DPS) are used, as free cash flow is difficult to estimate and often not reported by analysts. This often underestimates the value of a stock, but it can still be good as a comparison to competitors. We use the Gordon Growth Model, which assumes dividend will grow into 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 1.4%. We then discount this figure to today's value at a cost of equity of 10.0%. Relative to the current share price of UK£1.7, the company appears quite good value at a 49% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

Value Per Share = Expected Dividend Per Share / (Discount Rate - Perpetual Growth Rate)

= US$0.4 / (10.0% – 1.4%)

= UK£3.4

dcf

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at Ithaca 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 accounts for debt. In this calculation we've used 10.0%, which is based on a levered beta of 1.452. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

SWOT Analysis for Ithaca Energy

Strength

• Debt is not viewed as a risk.

• Dividend is in the top 25% of dividend payers in the market.

Weakness

• No major weaknesses identified for ITH.

Opportunity

• Expected to breakeven next year.

• Has sufficient cash runway for more than 3 years based on current free cash flows.

• Trading below our estimate of fair value by more than 20%.

Threat

• Paying a dividend but company is unprofitable.

• Revenue is forecast to decrease over the next 2 years.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Ithaca Energy, there are three pertinent factors you should consider:

1. Risks: We feel that you should assess the 1 warning sign for Ithaca Energy we've flagged before making an investment in the company.

2. Future Earnings: How does ITH's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.

3. Other Solid Businesses: 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 business fundamentals to see if there are other companies you may not have considered!

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

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.