Calculating The Fair Value Of Morgan Advanced Materials plc (LON:MGAM)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Morgan Advanced Materials fair value estimate is UK£2.64

• Current share price of UK£2.91 suggests Morgan Advanced Materials is potentially trading close to its fair value

• Our fair value estimate is 31% lower than Morgan Advanced Materials' analyst price target of UK£3.83

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Morgan Advanced Materials plc (LON:MGAM) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. It may sound complicated, but actually it is quite simple!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

View our latest analysis for Morgan Advanced Materials

The Calculation

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 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.

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) forecast

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (£, Millions)	UK£34.7m	UK£62.3m	UK£64.1m	UK£65.4m	UK£66.7m	UK£67.8m	UK£68.9m	UK£69.9m	UK£70.9m	UK£71.8m
Growth Rate Estimate Source	Analyst x3	Analyst x4	Analyst x2	Est @ 2.17%	Est @ 1.89%	Est @ 1.70%	Est @ 1.56%	Est @ 1.46%	Est @ 1.40%	Est @ 1.35%
Present Value (£, Millions) Discounted @ 9.4%	UK£31.7	UK£52.0	UK£48.9	UK£45.6	UK£42.5	UK£39.5	UK£36.6	UK£34.0	UK£31.5	UK£29.1

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£391m

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 1.2%. We discount the terminal cash flows to today's value at a cost of equity of 9.4%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = UK£72m× (1 + 1.2%) ÷ (9.4%– 1.2%) = UK£886m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£886m÷ ( 1 + 9.4%)¹⁰= UK£360m

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 UK£751m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK£2.9, the company appears around fair value at the time of writing. 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.

dcf

Important 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. 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 Morgan Advanced Materials 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 9.4%, which is based on a levered beta of 1.177. 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.

SWOT Analysis for Morgan Advanced Materials

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is well covered by earnings.

Weakness

• Dividend is low compared to the top 25% of dividend payers in the Machinery market.

Opportunity

• Annual earnings are forecast to grow for the next 3 years.

• Good value based on P/E ratio compared to estimated Fair P/E ratio.

Threat

• Debt is not well covered by operating cash flow.

• Paying a dividend but company has no free cash flows.

• Annual earnings are forecast to grow slower than the British market.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. 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. For Morgan Advanced Materials, we've put together three essential items you should further research:

1. Risks: Case in point, we've spotted 2 warning signs for Morgan Advanced Materials you should be aware of, and 1 of them makes us a bit uncomfortable.

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for MGAM's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

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 British stock every day, so if you want to find the intrinsic value of any other stock just search here.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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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