A look at the fair value of Core Lithium Ltd (ASX:CXO)

Key findings

• Using 2-step free cash flow to equity, the fair value of Core Lithium is AU$0.092.

• With a share price of AU$0.093, Core Lithium appears to be trading close to its estimated fair value

• Our fair value estimate is 13% below Core Lithium’s analyst price target of AU$0.11.

How far is Core Lithium Ltd (ASX:CXO) from its intrinsic value? Using the most recent financial data, we will check whether the stock is fairly valued by projecting its future cash flows and then discounting those to today’s value. To do this, we will use the Discounted Cash Flow (DCF) model. Don’t be put off by the technical jargon, the math behind it is actually quite simple.

We generally believe that the value of a company is the present value of all the cash it will generate in the future. However, a DCF is just one valuation metric among many and is not without its flaws. For those who enjoy stock analysis, the Simply Wall St analysis model presented here might be of interest.

Check out our latest analysis for Core Lithium

The calculation

We use a two-stage DCF model which, as the name suggests, considers two phases of growth. The first stage is generally a higher growth phase that stabilizes toward the terminal value captured in the second “steady growth” stage. First, we need to obtain 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 that companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will slow their growth rate over this period. We do this to take into account that growth tends to slow more in the early years than in later years.

In general, we assume that a dollar today is worth more than a dollar in the future. Therefore, we discount the value of these future cash flows to their estimated value in today’s dollars:

10-year free cash flow (FCF) forecast

(“Est” = FCF growth rate, estimated by Simply Wall St)
Present value of 10-year cash flow (PVCF) = AU$12 million

The story goes on

We now need to calculate the terminal value that takes into account all future cash flows after this ten-year period. For various reasons, a very conservative growth rate is used that cannot exceed a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (2.3%) 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 7.4%.

Final value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$19 million × (1 + 2.3%) ÷ (7.4% – 2.3%) = AU$380 million

Present value of terminal value (PVTV)= TV / (1 + r)¹⁰= AU$380 million ÷ ( 1 + 7.4 %)¹⁰= AU$185 million

Total value is the sum of the next ten years’ cash flows plus the discounted terminal value, giving the total equity value, which in this case is AU$197 million. The final step is to divide the equity value by the number of shares outstanding. Compared to the current share price of AU$0.09, the company is roughly at fair value at the time of writing. However, valuations are imprecise instruments, much like a telescope – move a few degrees and you end up in another galaxy. Keep this in mind.

Important assumptions

The above calculation relies heavily on two assumptions. The first is the discount rate and the other is the cash flows. You don’t have to agree with these inputs, I recommend repeating the calculations yourself and playing with them. The DCF also doesn’t take into account the possible cyclicality of an industry or a company’s future capital needs and therefore doesn’t provide a complete picture of a company’s potential performance. Since we consider Core Lithium 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 takes debt into account. In this calculation, we used 7.4% which is based on a leveraged beta of 1.128. Beta is a measure of a stock’s volatility relative to the overall market. We get our beta from the industry average beta of globally comparable companies with an imposed limit of between 0.8 and 2.0 which is a reasonable range for a stable company.

SWOT Analysis for Core Lithium

Strength

weakness

Opportunity

Danger

Next Steps:

While valuing a company is important, ideally it shouldn’t be the only analysis you look at for a company. The DCF model isn’t a perfect stock valuation tool. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. If a company grows differently, or its cost of equity or risk-free rate changes significantly, the outcome could be very different. For Core Lithium, we’ve put together three basic elements to look at:

1. Risks: Take risks, for example – Core Lithium has 2 warning signs (and 1 that can’t be ignored) that we think you should know about.

2. Future income: How is CXO’s growth rate compared to competitors and the overall market? Learn more about analyst consensus numbers for the coming years by using our free chart of analyst growth expectations.

3. Other solid companies: Low debt, high returns on equity, and good past performance are the foundation of a strong company. Check out our interactive list of stocks with solid business fundamentals to see if there are any other companies you may not have considered!

PS Simply Wall St updates its DCF calculation for each Australian stock daily, so if you want to find out the intrinsic value of another stock, just search here.

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This Simply Wall St article is of a general nature. We comment solely on historical data and analyst forecasts, using an unbiased methodology. Our articles do not constitute financial advice. It is not a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. Our goal is to provide you with long-term analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative materials. Simply Wall St does not hold any of the stocks mentioned.

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