Is There An Opportunity With The Star Entertainment Group Limited's (ASX:SGR) 49% Undervaluation?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Star Entertainment Group fair value estimate is AU$1.19
• Star Entertainment Group's AU$0.60 share price signals that it might be 49% undervalued
• Our fair value estimate is 14% higher than Star Entertainment Group's analyst price target of AU$1.04

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of The Star Entertainment Group Limited (ASX:SGR) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. It may sound complicated, but actually it is quite simple!

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 still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out our latest analysis for Star Entertainment Group

What's The Estimated Valuation?

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 start off with, we need to estimate 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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	-AU$14.0m	AU$11.0m	AU$219.0m	AU$216.0m	AU$237.0m	AU$252.5m	AU$265.7m	AU$276.9m	AU$286.8m	AU$295.7m
Growth Rate Estimate Source	Analyst x2	Analyst x1	Analyst x1	Analyst x1	Analyst x1	Est @ 6.56%	Est @ 5.20%	Est @ 4.24%	Est @ 3.57%	Est @ 3.10%
Present Value (A$, Millions) Discounted @ 8.2%	-AU$12.9	AU$9.4	AU$173	AU$157	AU$160	AU$157	AU$153	AU$147	AU$141	AU$134

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$1.2b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 8.2%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$296m× (1 + 2.0%) ÷ (8.2%– 2.0%) = AU$4.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$4.9b÷ ( 1 + 8.2%)¹⁰= AU$2.2b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$3.4b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of AU$0.6, the company appears quite good value at a 49% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

Important Assumptions

We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual 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 Star Entertainment 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 8.2%, which is based on a levered beta of 1.243. 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 Star Entertainment Group

Looking Ahead:

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. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price sitting below the intrinsic value? For Star Entertainment Group, we've put together three fundamental factors you should further research:

1. Risks: We feel that you should assess the 2 warning signs for Star Entertainment Group (1 doesn't sit too well with us!) we've flagged before making an investment in the company.
2. Future Earnings: How does SGR'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.
3. 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.