Don’t Miss the Value in Valero Energy Corporation (VLO)

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The refinery business isn’t very exciting, but it can be profitable. With the growth in American energy production and ban on raw crude exports, many refineries have seen their business boom. Using a simple two-stage discounted cash flow calculation, Valero Energy Corporation (NYSE:VLO) stands out as a refiner that is undervalued with an attractive future.

VLO Free Cash Flow Per Share TTM data by YCharts

Two Stage Discounted Cash Flow Analysis

The basic idea behind discounted cash flow analysis is simple. You get the value of a company by looking at all of its future cash flow. By using free cash flow you can see how much cash a company really produces, apart from its normal business costs. This article uses a two-stage analysis with a high-growth stage and a later low-growth stage.

Valero Energy Corporation (NYSE:VLO)

After getting a company’s free cash flow, you take a look at the company’s growth rate and the required rate of return. A good rule of thumb for the required return rate is the ten year Treasury rate plus five percent. In this model the high growth stage uses the current ten year rate around 2.57% plus 5%. For the second period a higher 3.57% rate plus 5% is used. A higher rate is used for the second stage, because the end of the government’s quantitative easing program should boost interest rates.

The expected 2014 earnings per share (EPS) growth rate is a good place to find the high-growth stage rate. For the second stage a stable 3% growth rate is used. Using all of these numbers you can calculate the intrinsic value of any company.

VLO data by YCharts

A Diamond in the Rough

A quick look at the Energy Information Agency’s (EIA) latest numbers shows that Valero Energy Corporation (NYSE:VLO) is the biggest refiner in the U.S., followed by Exxon Mobil Corporation (NYSE:XOM) and Phillips 66 (NYSE:PSX). Valero’s size serves as an asset for the company. In 2013 it is upgrading its logistics operations to help buy more cheap North American crude and less expensive imported crude. It is expecting to spend $250 million to expand its rail car fleet. These rail cars help to decrease the company’s reliance on pipelines.

Valero Energy Corporation (NYSE:VLO) is also looking to take advantage of the spread between cheap natural gas and expensive diesel fuel with hydrocrackers. Its new hydrocracker facilities will boost its bottom-line and help differentiate the company from its competitors.

Valero’s Intrinsic Value

Plugging in Valero Energy Corporation (NYSE:VLO)’s current free cash flow per share of $4.261 and its expected 2014 EPS growth rate of 5.99% into a two stage discounted cash flow calculator gives an intrinsic value of $87.78 per share. It is important to note that this calculator uses a three year high-growth stage and then a permanent lower growth stage. An intrinsic value of $87.78 is a substantial increase from Valero’s current share price of around $35.

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