Mastech Digital, Inc.'s (NYSEMKT:MHH) Intrinsic Value Is Potentially 96% Above Its Share Price

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Mastech Digital, Inc. (NYSEMKT:MHH) as an investment opportunity by taking the expected future cash flows and discounting them to today's 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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

See our latest analysis for Mastech Digital

The method

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. 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) estimate

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF ($, Millions)	US$9.09m	US$19.5m	US$20.3m	US$21.1m	US$21.7m	US$22.3m	US$22.9m	US$23.5m	US$24.0m	US$24.5m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ 4.22%	Est @ 3.56%	Est @ 3.11%	Est @ 2.79%	Est @ 2.56%	Est @ 2.41%	Est @ 2.3%	Est @ 2.22%
Present Value ($, Millions) Discounted @ 7.1%	US$8.5	US$17.0	US$16.5	US$16.0	US$15.4	US$14.8	US$14.1	US$13.5	US$12.9	US$12.3

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$141m

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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 7.1%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = US$25m× (1 + 2.0%) ÷ (7.1%– 2.0%) = US$491m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$491m÷ ( 1 + 7.1%)¹⁰= US$246m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$387m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of US$17.4, 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.

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 Mastech Digital 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 0.975. 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.

Looking Ahead:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. 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. Why is the intrinsic value higher than the current share price? For Mastech Digital, we've compiled three further aspects you should further research:

1. Risks: Every company has them, and we've spotted 1 warning sign for Mastech Digital you should know about.
2. Future Earnings: How does MHH'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: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. Simply Wall St updates its DCF calculation for every American 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. 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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