Today we will run through one way of estimating the intrinsic value of Melrose Industries PLC (LON:MRO) by estimating the company's future cash flows and discounting them to their present value. This is done using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
Is Melrose Industries fairly valued?
We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. 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.
Generally we assume that a dollar today is more valuable than a dollar in the future, 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
|Levered FCF (£, Millions)||UK£336.9m||UK£591.1m||UK£634.8m||UK£665.0m||UK£688.2m||UK£706.1m||UK£720.1m||UK£731.2m||UK£740.3m||UK£747.9m|
|Growth Rate Estimate Source||Analyst x5||Analyst x6||Analyst x3||Est @ 4.76%||Est @ 3.49%||Est @ 2.6%||Est @ 1.98%||Est @ 1.54%||Est @ 1.24%||Est @ 1.03%|
|Present Value (£, Millions) Discounted @ 10%||UK£306||UK£488||UK£476||UK£452||UK£425||UK£396||UK£367||UK£339||UK£311||UK£286|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£3.8b
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 10-year government bond rate (0.5%) 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 10%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = UK£748m× (1 + 0.5%) ÷ 10%– 0.5%) = UK£7.9b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£7.9b÷ ( 1 + 10%)10= UK£3.0b
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£6.8b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of UK£1.0, the company appears a touch undervalued at a 29% 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.
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 Melrose Industries 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 10%, which is based on a levered beta of 1.577. 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.
Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. 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. What is the reason for the share price to differ from the intrinsic value? For Melrose Industries, We've compiled three further aspects you should further examine:
- Risks: Every company has them, and we've spotted 4 warning signs for Melrose Industries (of which 1 can't be ignored!) you should know about.
- Future Earnings: How does MRO'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 LSE every day. If you want to find the calculation for other stocks just search here.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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