Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of McMillan Shakespeare Limited (ASX:MMS) as an investment opportunity by taking the expected future cash flows and discounting them to today’s value. I will use the Discounted Cash Flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. If you want to learn more about discounted cash flow, the basis for my calcs can be read in detail in the Simply Wall St analysis model. Please also note that this article was written in January 2019 so be sure check out the updated calculation by following the link below.
What’s the value?
I’m 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 perpetual stable growth rate. To begin with we have to get estimates of the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount this to its value today and sum up the total to get the present value of these cash flows.
5-year cash flow forecast
|Levered FCF (A$, Millions)||A$75.15||A$91.87||A$112.15||A$125.34||A$140.07|
|Source||Analyst x2||Analyst x3||Analyst x2||Est @ 11.76%||Est @ 11.76%|
|Present Value Discounted @ 9.64%||A$68.54||A$76.42||A$85.08||A$86.72||A$88.40|
Present Value of 5-year Cash Flow (PVCF)= AU$405m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after the five years. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (2.3%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 9.6%.
Terminal Value (TV) = FCF2023 × (1 + g) ÷ (r – g) = AU$140m × (1 + 2.3%) ÷ (9.6% – 2.3%) = AU$2.0b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = AU$2.0b ÷ ( 1 + 9.6%)5 = AU$1.2b
The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is AU$1.6b. In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number. This results in an intrinsic value of A$19.82. Relative to the current share price of A$15.51, the stock is about right, perhaps slightly undervalued at a 22% discount to what it is available for right now.
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. You don’t have to agree with my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at McMillan Shakespeare as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 9.6%, which is based on a levered beta of 0.954. This is derived from the Bottom-Up Beta method based on 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. What is the reason for the share price to differ from the intrinsic value? For MMS, there are three essential factors you should further examine:
- Financial Health: Does MMS have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does MMS’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 High Quality Alternatives: Are there other high quality stocks you could be holding instead of MMS? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. The Simply Wall St app conducts a discounted cash flow for every stock on the ASX every 6 hours. If you want to find the calculation for other stocks just search here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.