How far off is Mercury NZ Limited (NZSE:MCY) 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 today's value. This will be done using the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
Is Mercury NZ Fairly Valued?
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 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, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) forecast
|Levered FCF (NZ$, Millions)||NZ$531.6m||NZ$374.9m||NZ$446.0m||NZ$448.0m||NZ$447.0m||NZ$449.2m||NZ$453.5m||NZ$459.4m||NZ$466.5m||NZ$474.4m|
|Growth Rate Estimate Source||Analyst x1||Analyst x2||Analyst x1||Analyst x1||Analyst x1||Est @ 0.48%||Est @ 0.97%||Est @ 1.3%||Est @ 1.54%||Est @ 1.7%|
|Present Value (NZ$, Millions) Discounted @ 6.2%||NZ$501||NZ$332||NZ$372||NZ$352||NZ$331||NZ$313||NZ$298||NZ$284||NZ$272||NZ$260|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NZ$3.3b
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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 6.2%.
Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = NZ$474m× (1 + 2.1%) ÷ (6.2%– 2.1%) = NZ$12b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= NZ$12b÷ ( 1 + 6.2%)10= NZ$6.5b
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 NZ$9.8b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of NZ$5.6, the company appears a touch undervalued at a 20% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Mercury NZ 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 6.2%, which is based on a levered beta of 0.800. 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 Mercury NZ
- Earnings growth over the past year exceeded its 5-year average.
- Debt is well covered by earnings.
- Earnings growth over the past year underperformed the Electric Utilities industry.
- Dividend is low compared to the top 25% of dividend payers in the Electric Utilities market.
- Good value based on P/E ratio and estimated fair value.
- Significant insider buying over the past 3 months.
- Debt is not well covered by operating cash flow.
- Dividends are not covered by cash flow.
- Annual earnings are forecast to decline for the next 3 years.
Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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 Mercury NZ, we've compiled three additional elements you should explore:
- Risks: For example, we've discovered 3 warning signs for Mercury NZ (1 is a bit unpleasant!) that you should be aware of before investing here.
- Future Earnings: How does MCY'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.
- 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.
Valuation is complex, but we're helping make it simple.
Find out whether Mercury NZ is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.View the Free Analysis
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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.