Stock Analysis

# Calculating The Fair Value Of Midway Limited (ASX:MWY)

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Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Midway Limited (ASX:MWY) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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.

See our latest analysis for Midway

### Is Midway fairly valued?

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 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 discount the value of these future cash flows to their estimated value in today's dollars:

#### 10-year free cash flow (FCF) estimate

 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 Levered FCF (A\$, Millions) AU\$10.9m AU\$6.30m AU\$10.1m AU\$8.78m AU\$8.03m AU\$7.59m AU\$7.34m AU\$7.22m AU\$7.18m AU\$7.19m Growth Rate Estimate Source Analyst x1 Analyst x1 Analyst x1 Est @ -13.08% Est @ -8.58% Est @ -5.43% Est @ -3.23% Est @ -1.68% Est @ -0.6% Est @ 0.16% Present Value (A\$, Millions) Discounted @ 11% AU\$9.8 AU\$5.1 AU\$7.4 AU\$5.8 AU\$4.7 AU\$4.0 AU\$3.5 AU\$3.1 AU\$2.8 AU\$2.5

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU\$48m

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 5-year average of the 10-year government bond yield (1.9%) 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 11%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = AU\$7.2m× (1 + 1.9%) ÷ (11%– 1.9%) = AU\$79m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU\$79m÷ ( 1 + 11%)10= AU\$28m

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\$76m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of AU\$1.0, the company appears around fair value at the time of writing. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

### The 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. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Midway 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 11%, which is based on a levered beta of 1.954. 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.

### Next Steps:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Midway, there are three additional items you should explore:

1. Risks: For instance, we've identified 1 warning sign for Midway that you should be aware of.
2. Future Earnings: How does MWY'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 High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. Simply Wall St updates its DCF calculation for every Australian stock every day, so if you want to find the intrinsic value of any other stock just search here.

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