Does This Valuation Of Meridian Energy Limited (NZSE:MEL) Imply Investors Are Overpaying?

By
Simply Wall St
Published
October 24, 2019
NZSE:MEL

Today we will run through one way of estimating the intrinsic value of Meridian Energy Limited (NZSE:MEL) by taking the expected future cash flows and discounting them to their present value. I will be using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

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 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 Meridian Energy

The model

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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
Levered FCF (NZ$, Millions) NZ$602.5m NZ$534.0m NZ$524.0m NZ$521.3m NZ$523.2m NZ$528.2m NZ$535.5m NZ$544.5m NZ$554.8m NZ$566.1m
Growth Rate Estimate Source Analyst x2 Analyst x2 Analyst x1 Est @ -0.51% Est @ 0.36% Est @ 0.96% Est @ 1.38% Est @ 1.68% Est @ 1.89% Est @ 2.03%
Present Value (NZ$, Millions) Discounted @ 7.1% NZ$562 NZ$465 NZ$426 NZ$396 NZ$371 NZ$349 NZ$331 NZ$314 NZ$298 NZ$284

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NZ$3.8b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 10-year government bond rate of 2.4%. We discount the terminal cash flows to today's value at a cost of equity of 7.1%.

Terminal Value (TV)= FCF2019 × (1 + g) ÷ (r – g) = NZ$566m× (1 + 2.4%) ÷ 7.1%– 2.4%) = NZ$12b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= NZ$12b÷ ( 1 + 7.1%)10= NZ$6.1b

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$9.9b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of NZ$5.0, the company appears slightly overvalued at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

NZSE:MEL Intrinsic value, October 25th 2019
NZSE:MEL Intrinsic value, October 25th 2019

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 Meridian Energy 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 7.1%, 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.

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. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/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. What is the reason for the share price to differ from the intrinsic value? For Meridian Energy, There are three further factors you should look at:

  1. Financial Health: Does MEL have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
  2. Future Earnings: How does MEL'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: Are there other high quality stocks you could be holding instead of MEL? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.

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