Today I will be providing a simple run-through of the discounted cash flows (DCF) method to estimate the attractiveness of Melbourne IT Limited (ASX:MLB) as an investment opportunity. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. Also note that this article was written in February 2018 so be sure check the latest calculation for Melbourne IT here.
Crunching the numbers
I’ve used the 2-stage growth model, which simply means we have two different periods of varying growth rates for the company’s cash flows. Generally the initial phase has higher growth rates that plateau over time. To begin, I pulled together the analyst consensus forecast of MLB’s levered free cash flow (FCF) over the next five years and discounted these figures at the cost of equity of 8.55%. When estimates weren’t available, I’ve extrapolated the average annual growth rate over the previous five years, capped at a reasonable level. This resulted in a present value of 5-year cash flow of A$149.9M. Keen to know how I calculated this value? Take a look at our detailed analysis here.
In the visual above, we see how how MLB’s earnings are expected to move in the future, which should give you an idea of MLB’s outlook. Secondly, I determine the terminal value, which accounts for all the future cash flows after the five years. It’s appropriate to use the 10-year government bond rate of 2.8% as the stable growth rate, which is rightly below GDP growth, but more towards the conservative side. Discounting the terminal value back five years gives us a present value of A$547.6M.
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is A$697.5M. The last step is to then divide the equity value by the number of shares outstanding. This results in an intrinsic value of A$5.94, which, compared to the current share price of A$3.34, we find that Melbourne IT is quite undervalued at a 43.80% discount to what it is available for right now.
Next Steps:
Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For MLB, I’ve put together three essential aspects you should further examine:
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1. Financial Health: Does MLB 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.
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2. Future Earnings: How does MLB’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.
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2. Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of MLB? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!