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Does the May share price for MGM China Holdings Limited (HKG:2282) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to their present value. I will be using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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.
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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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 are 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
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
Levered FCF (HK$, Millions)
HK$5.02k
HK$5.54k
HK$6.14k
HK$6.62k
HK$7.02k
HK$7.36k
HK$7.65k
HK$7.91k
HK$8.15k
HK$8.37k
Growth Rate Estimate Source
Analyst x4
Analyst x8
Analyst x4
Est @ 7.8%
Est @ 6.06%
Est @ 4.84%
Est @ 3.99%
Est @ 3.39%
Est @ 2.98%
Est @ 2.69%
Present Value (HK$, Millions) Discounted @ 8.69%
HK$4.62k
HK$4.69k
HK$4.78k
HK$4.74k
HK$4.63k
HK$4.46k
HK$4.27k
HK$4.06k
HK$3.85k
HK$3.63k
Present Value of 10-year Cash Flow (PVCF)= HK$43.73b
"Est" = FCF growth rate estimated by Simply Wall St
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 10-year government bond rate of 2%. We discount the terminal cash flows to today's value at a cost of equity of 8.7%.
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = HK$HK$128b ÷ ( 1 + 8.7%)10 = HK$55.40b
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 HK$99.13b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. This results in an intrinsic value estimate of HK$26.09. Compared to the current share price of HK$16, the company appears quite good value at a 39% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.
SEHK:2282 Intrinsic value, May 5th 2019
The assumptions
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 MGM China Holdings 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 8.7%, which is based on a levered beta of 1.123. 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:
Although the valuation of a company is important, 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 MGM China Holdings, I've put together three important factors you should further research:
Future Earnings: How does 2282'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 High Quality Alternatives: Are there other high quality stocks you could be holding instead of 2282? 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 HK stock every day, so if you want to find the intrinsic value of any other stock 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.
