Proactive Investors - The discounted cash flow (DCF) methodology is a way to estimate the value of an oil exploration company. It does this by looking at how much money the company is expected to make in the future and then "discounting" it back to the present day. This approach should help when it comes to valuing the likes of Harbour Energy PLC (LSE:HBR), IGas Energy PLC (AIM:IGAS, OTC:IGESF), or Hurricane Energy PLC (LSE:HUR).
Here's how it works:
First, we need to forecast how much money the company will make in the future. This includes estimating how much oil the company will find and sell, and how much money it will make from those sales.
Next, we need to figure out how much those future cash flows are worth today. To do this, we use something called a "discount rate." This is a percentage that represents the time value of money, or the idea that a dollar today is worth more than a dollar in the future.
Finally, we add up all of the discounted cash flows to get the DCF value of the company.
This how we do it, do it
Let's say we have an oil exploration company that is expected to make $100 in profits next year, $200 in profits the year after that, and $300 in profits the year after that. Using a discount rate of 10%, we can figure out the present value of those cash flows like this:
Year 1: $100 / (1 + 10%) = $90.91
Year 2: $200 / (1 + 10%)^2 = $162.81
Year 3: $300 / (1 + 10%)^3 = $217.74
Total DCF value: $90.91 + $162.81 + $217.74 = $471.46
This means that the DCF value of the company is $471.46.
Now, there are a few things to keep in mind when using the DCF methodology. First, the forecasted cash flows and discount rate are both estimates, so the DCF value will also be an estimate. It's important to be as accurate as possible when making these estimates, but it's also important to recognize that they are just estimates and that the actual value of the company could be different.
Second, the DCF value is only one way to estimate the value of a company. There are other methods that can be used, and it's often a good idea to compare the results of different methods to get a more complete picture of a company's value.
Finally, it's important to remember that the DCF methodology is based on the assumption that the company will continue to make money in the future. This means that it's not a good way to
The discounted cash flow (DCF) methodology has both strengths and weaknesses when it comes to analyzing oil exploration companies.
Some strengths of DCF include:
It is based on actual cash flows: DCF values a company based on the cash it is expected to generate in the future, which is an important factor in a company's value.
It considers the time value of money: The discount rate used in DCF reflects the fact that a dollar today is worth more than a dollar in the future, which is important when valuing a company.
It can be customized: DCF can be tailored to the specific characteristics of a company, such as its growth rate and risk level, which makes it a flexible tool for valuation.
However, there are also some weaknesses to consider:
It relies on estimates: The cash flows and discount rate used in DCF are both estimates, which means that the resulting DCF value is also an estimate. This can lead to uncertainty and can make it difficult to compare the results of different valuation methods.
It may not capture all aspects of a company's value: DCF is based on the assumption that the company will continue to generate cash flows in the future, so it may not be suitable for companies that are expected to go bankrupt or stop making profits in the near future.
It may be sensitive to changes in assumptions: Small changes in the assumptions used in DCF, such as the growth rate or discount rate, can have a big impact on the resulting value. This can make it difficult to compare the results of different analyses.
Overall, it is important to consider the strengths and weaknesses of DCF when using it to analyze oil exploration companies and to consider using a combination of valuation methods to get a more complete picture of a company's value.
what are the alternatives to DCF when analyzing oil exploration companies
And some other methods
There are several alternatives to the discounted cash flow (DCF) methodology that can be used to analyze oil exploration companies. Some common ones include:
Comparable company analysis: This involves comparing the company being analyzed to similar companies in the same industry. The financial ratios and stock prices of these comparable companies can be used to estimate the value of the company being analyzed.
Precedent transaction analysis: This involves looking at the prices paid for similar companies in the past and using those prices as a benchmark for the company being analyzed.
Dividend discount model: This method is similar to DCF, but instead of forecasting cash flows, it focuses on the company's dividends. The dividends are discounted back to the present day to estimate the value of the company.
Sum-of-the-parts analysis: This involves breaking the company down into its different parts (e.g., different projects or assets) and valuing each part separately. The total value of the company is then the sum of the values of its individual parts.
Net asset value: This method involves valuing the company based on the value of its assets, such as oil reserves and equipment, minus its liabilities.
It's worth noting that each of these methods has its own strengths and limitations, and it can be helpful to use a combination of methods to get a more complete picture of a company's value.