A Look At The Fair Value Of Union Jack Oil plc (LON:UJO)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Union Jack Oil fair value estimate is UK£0.23

• With UK£0.19 share price, Union Jack Oil appears to be trading close to its estimated fair value

Today we will run through one way of estimating the intrinsic value of Union Jack Oil plc (LON:UJO) by taking the expected future cash flows and discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. There's really not all that much to it, even though it might appear quite complex.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

View our latest analysis for Union Jack Oil

Step By Step Through The Calculation

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (£, Millions)	UK£1.50m	UK£1.57m	UK£1.63m	UK£1.68m	UK£1.73m	UK£1.76m	UK£1.80m	UK£1.83m	UK£1.86m	UK£1.89m
Growth Rate Estimate Source	Analyst x1	Est @ 4.85%	Est @ 3.81%	Est @ 3.08%	Est @ 2.57%	Est @ 2.21%	Est @ 1.96%	Est @ 1.79%	Est @ 1.67%	Est @ 1.58%
Present Value (£, Millions) Discounted @ 8.2%	UK£1.4	UK£1.3	UK£1.3	UK£1.2	UK£1.2	UK£1.1	UK£1.0	UK£1.0	UK£0.9	UK£0.9

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£11m

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (1.4%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 8.2%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£1.9m× (1 + 1.4%) ÷ (8.2%– 1.4%) = UK£28m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£28m÷ ( 1 + 8.2%)¹⁰= UK£13m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is UK£24m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK£0.2, the company appears about fair value at a 17% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Union Jack Oil 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 8.2%, which is based on a levered beta of 1.148. 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 Union Jack Oil

Strength

• Currently debt free.

Weakness

• Dividend is low compared to the top 25% of dividend payers in the Oil and Gas market.

Opportunity

• Current share price is below our estimate of fair value.

• Significant insider buying over the past 3 months.

Threat

• No apparent threats visible for UJO.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Union Jack Oil, there are three relevant factors you should consider:

1. Risks: To that end, you should be aware of the 2 warning signs we've spotted with Union Jack Oil .

2. Future Earnings: How does UJO'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the AIM every day. If you want to find the calculation for other stocks 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.