Estimating The Fair Value Of Kip McGrath Education Centres Limited (ASX:KME)

Key Insights

• Kip McGrath Education Centres' estimated fair value is AU$0.28 based on 2 Stage Free Cash Flow to Equity

• With AU$0.34 share price, Kip McGrath Education Centres appears to be trading close to its estimated fair value

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Kip McGrath Education Centres Limited (ASX:KME) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. There's really not all that much to it, even though it might appear quite complex.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for Kip McGrath Education Centres

Crunching The Numbers

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. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	AU$951.7k	AU$861.7k	AU$810.3k	AU$781.7k	AU$767.5k	AU$762.7k	AU$764.3k	AU$770.3k	AU$779.6k	AU$791.2k
Growth Rate Estimate Source	Est @ -14.43%	Est @ -9.45%	Est @ -5.97%	Est @ -3.53%	Est @ -1.82%	Est @ -0.63%	Est @ 0.21%	Est @ 0.79%	Est @ 1.20%	Est @ 1.49%
Present Value (A$, Millions) Discounted @ 6.4%	AU$0.9	AU$0.8	AU$0.7	AU$0.6	AU$0.6	AU$0.5	AU$0.5	AU$0.5	AU$0.4	AU$0.4

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$5.9m

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 2.2%. We discount the terminal cash flows to today's value at a cost of equity of 6.4%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$791k× (1 + 2.2%) ÷ (6.4%– 2.2%) = AU$19m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$19m÷ ( 1 + 6.4%)¹⁰= AU$10m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$16m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of AU$0.3, 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

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Kip McGrath Education Centres 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 6.4%, which is based on a levered beta of 0.920. 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:

Valuation is only one side of the coin in terms of building your investment thesis, and it 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. For Kip McGrath Education Centres, we've put together three further factors you should explore:

1. Risks: Case in point, we've spotted 3 warning signs for Kip McGrath Education Centres you should be aware of, and 1 of them makes us a bit uncomfortable.

2. 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!

3. Other Environmentally-Friendly Companies: Concerned about the environment and think consumers will buy eco-friendly products more and more? Browse through our interactive list of companies that are thinking about a greener future to discover some stocks you may not have thought of!

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