Estimating The Intrinsic Value Of SkyCity Entertainment Group Limited (NZSE:SKC)

How far off is SkyCity Entertainment Group Limited (NZSE:SKC) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing 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 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 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.

View our latest analysis for SkyCity Entertainment Group

What's the estimated valuation?

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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.

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

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (NZ$, Millions)	-NZ$56.7m	NZ$25.0m	NZ$34.0m	NZ$222.5m	NZ$231.5m	NZ$239.0m	NZ$246.0m	NZ$252.8m	NZ$259.4m	NZ$265.8m
Growth Rate Estimate Source	Analyst x3	Analyst x3	Analyst x3	Analyst x2	Analyst x2	Est @ 3.24%	Est @ 2.95%	Est @ 2.74%	Est @ 2.6%	Est @ 2.5%
Present Value (NZ$, Millions) Discounted @ 8.7%	-NZ$52.1	NZ$21.1	NZ$26.4	NZ$159	NZ$152	NZ$145	NZ$137	NZ$129	NZ$122	NZ$115

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NZ$954m

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 2.3%. We discount the terminal cash flows to today's value at a cost of equity of 8.7%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = NZ$266m× (1 + 2.3%) ÷ (8.7%– 2.3%) = NZ$4.2b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= NZ$4.2b÷ ( 1 + 8.7%)¹⁰= NZ$1.8b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is NZ$2.8b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of NZ$3.2, the company appears about fair value at a 13% 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

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 SkyCity 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 8.7%, which is based on a levered beta of 1.237. 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.

Moving On:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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. For SkyCity Entertainment Group, we've put together three further factors you should assess:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with SkyCity Entertainment Group (at least 1 which shouldn't be ignored) , and understanding them should be part of your investment process.
2. Future Earnings: How does SKC'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 NZSE 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. 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.
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