Key Insights

• Using the 2 Stage Free Cash Flow to Equity, BHP Group fair value estimate is AU$57.07

• BHP Group's AU$43.43 share price signals that it might be 24% undervalued

• Our fair value estimate is 23% higher than BHP Group's analyst price target of US$46.31

Does the October share price for BHP Group Limited (ASX:BHP) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by estimating the company's future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

See our latest analysis for BHP Group

The Method

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. To begin with, we have to get estimates of 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF ($, Millions)	US$10.1b	US$9.46b	US$8.45b	US$11.8b	US$11.4b	US$11.2b	US$11.1b	US$11.2b	US$11.3b	US$11.5b
Growth Rate Estimate Source	Analyst x8	Analyst x8	Analyst x7	Analyst x1	Analyst x1	Est @ -1.65%	Est @ -0.43%	Est @ 0.42%	Est @ 1.02%	Est @ 1.43%
Present Value ($, Millions) Discounted @ 7.2%	US$9.4k	US$8.2k	US$6.9k	US$8.9k	US$8.0k	US$7.4k	US$6.8k	US$6.4k	US$6.0k	US$5.7k

("Est" = FCF growth rate estimated by Simply Wall St)Present Value of 10-year Cash Flow (PVCF) = US$74b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (2.4%) 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 7.2%.

Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = US$11b× (1 + 2.4%) ÷ (7.2%– 2.4%) = US$244b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$244b÷ ( 1 + 7.2%)10= US$121b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$195b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of AU$43.4, the company appears a touch undervalued at a 24% 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.

dcfThe Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 BHP Group 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 7.2%, which is based on a levered beta of 1.170. 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 BHP Group

Strength

• Debt is not viewed as a risk.

Weakness

• Earnings declined over the past year.

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

Opportunity

• Annual earnings are forecast to grow for the next 3 years.

• Good value based on P/E ratio and estimated fair value.

Threat

• Dividends are not covered by earnings.

• Annual earnings are forecast to grow slower than the Australian market.

Next Steps:

Although the valuation of a company is important, 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. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. Can we work out why the company is trading at a discount to intrinsic value? For BHP Group, there are three essential factors you should further examine:

Risks: Take risks, for example – BHP Group has 2 warning signs we think you should be aware of.

Future Earnings: How does BHP'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.

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 ASX every day. If you want to find the calculation for other stocks just search here.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.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.