Meridian Energy Limited's (NZSE:MEL) Intrinsic Value Is Potentially 97% Above Its Share Price

By
Simply Wall St
Published
December 31, 2021
NZSE:MEL
Source: Shutterstock

How far off is Meridian Energy Limited (NZSE:MEL) 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. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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.

See 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 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, 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

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Levered FCF (NZ$, Millions) NZ$480.0m NZ$244.0m NZ$372.0m NZ$508.0m NZ$676.0m NZ$803.9m NZ$915.3m NZ$1.01b NZ$1.09b NZ$1.16b
Growth Rate Estimate Source Analyst x1 Analyst x1 Analyst x1 Analyst x1 Analyst x1 Est @ 18.91% Est @ 13.87% Est @ 10.33% Est @ 7.86% Est @ 6.13%
Present Value (NZ$, Millions) Discounted @ 5.6% NZ$455 NZ$219 NZ$316 NZ$409 NZ$515 NZ$580 NZ$625 NZ$653 NZ$667 NZ$671

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NZ$5.1b

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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 5.6%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = NZ$1.2b× (1 + 2.1%) ÷ (5.6%– 2.1%) = NZ$34b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= NZ$34b÷ ( 1 + 5.6%)10= NZ$20b

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$25b. 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$4.9, the company appears quite undervalued at a 49% 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.

dcf
NZSE:MEL Discounted Cash Flow December 31st 2021

The assumptions

We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual 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 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 5.6%, 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:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. 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. Can we work out why the company is trading at a discount to intrinsic value? For Meridian Energy, we've compiled three fundamental aspects you should further examine:

  1. Risks: You should be aware of the 3 warning signs for Meridian Energy (2 are significant!) we've uncovered before considering an investment in the company.
  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for MEL's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
  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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