Is MGM China Holdings Limited (HKG:2282) Trading At A 36% Discount?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, MGM China Holdings fair value estimate is HK$13.44
• MGM China Holdings is estimated to be 36% undervalued based on current share price of HK$8.64
• The HK$13.85 analyst price target for 2282 is 3.0% more than our estimate of fair value

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of MGM China Holdings Limited (HKG:2282) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

View our latest analysis for MGM China Holdings

Crunching The Numbers

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (HK$, Millions)	HK$6.27b	HK$5.82b	HK$4.37b	HK$5.62b	HK$5.41b	HK$5.30b	HK$5.26b	HK$5.26b	HK$5.29b	HK$5.34b
Growth Rate Estimate Source	Analyst x3	Analyst x3	Analyst x2	Analyst x1	Est @ -3.72%	Est @ -2.01%	Est @ -0.82%	Est @ 0.02%	Est @ 0.60%	Est @ 1.01%
Present Value (HK$, Millions) Discounted @ 11%	HK$5.6k	HK$4.7k	HK$3.2k	HK$3.6k	HK$3.1k	HK$2.8k	HK$2.5k	HK$2.2k	HK$2.0k	HK$1.8k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = HK$32b

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 11%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = HK$5.3b× (1 + 2.0%) ÷ (11%– 2.0%) = HK$58b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= HK$58b÷ ( 1 + 11%)¹⁰= HK$20b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is HK$51b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of HK$8.6, the company appears quite good value at a 36% 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.

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 MGM China Holdings 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 1.599. 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:

Although the valuation of a company is important, it is only one of many factors that you need to assess for 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. 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. Can we work out why the company is trading at a discount to intrinsic value? For MGM China Holdings, there are three relevant items you should explore:

1. Risks: For example, we've discovered 2 warning signs for MGM China Holdings that you should be aware of before investing here.
2. Future Earnings: How does 2282'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. Simply Wall St updates its DCF calculation for every Hong Kong stock every day, so if you want to find the intrinsic value of any other stock 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.