Are Investors Undervaluing Tortilla Mexican Grill plc (LON:MEX) By 45%?

Key Insights

• Tortilla Mexican Grill's estimated fair value is UK£1.8 based on 2 Stage Free Cash Flow to Equity
• Current share price of UK£1.0 suggests Tortilla Mexican Grill is 45% undervalued
• Analyst price target for MEX is UK£1.28 which is 30% below our fair value estimate

Does the January share price for Tortilla Mexican Grill plc (LON:MEX) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by estimating the company's future cash flows and discounting them to their present 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.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. 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 Tortilla Mexican Grill

The Calculation

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.

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

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (£, Millions)	-UK£1.25m	UK£436.9k	UK£1.00m	UK£2.80m	UK£4.52m	UK£6.47m	UK£8.45m	UK£10.3m	UK£11.9m	UK£13.2m
Growth Rate Estimate Source	Analyst x3	Analyst x3	Analyst x1	Analyst x1	Est @ 61.34%	Est @ 43.24%	Est @ 30.56%	Est @ 21.69%	Est @ 15.48%	Est @ 11.13%
Present Value (£, Millions) Discounted @ 11%	-UK£1.1	UK£0.4	UK£0.7	UK£1.8	UK£2.7	UK£3.4	UK£4.0	UK£4.4	UK£4.6	UK£4.6

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£25m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 1.0%. We discount the terminal cash flows to today's value at a cost of equity of 11%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = UK£13m× (1 + 1.0%) ÷ (11%– 1.0%) = UK£131m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£131m÷ ( 1 + 11%)¹⁰= UK£45m

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£71m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of UK£1.0, the company appears quite undervalued at a 45% discount to where the stock price trades currently. 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

Now 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 Tortilla Mexican Grill 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 1.489. 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 Tortilla Mexican Grill

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and 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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Why is the intrinsic value higher than the current share price? For Tortilla Mexican Grill, we've put together three additional factors you should assess:

1. Risks: We feel that you should assess the 1 warning sign for Tortilla Mexican Grill we've flagged before making an investment in the company.
2. Future Earnings: How does MEX'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 AIM every day. If you want to find the calculation for other stocks just search here.

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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.