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An Intrinsic Calculation For McMillan Shakespeare Limited (ASX:MMS) Suggests It's 35% Undervalued

Today we will run through one way of estimating the intrinsic value of McMillan Shakespeare Limited (ASX:MMS) by taking the forecast future cash flows of the company and discounting them back to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for McMillan Shakespeare

Crunching The Numbers

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. 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.

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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

2023

2024

2025

2026

2027

2028

2029

2030

2031

2032

Levered FCF (A$, Millions)

AU$99.2m

AU$81.4m

AU$68.2m

AU$92.5m

AU$90.5m

AU$89.7m

AU$89.6m

AU$90.1m

AU$90.9m

AU$92.1m

Growth Rate Estimate Source

Analyst x1

Analyst x1

Analyst x1

Analyst x1

Est @ -2.15%

Est @ -0.93%

Est @ -0.07%

Est @ 0.53%

Est @ 0.95%

Est @ 1.24%

Present Value (A$, Millions) Discounted @ 7.4%

AU$92.3

AU$70.6

AU$55.0

AU$69.5

AU$63.3

AU$58.4

AU$54.3

AU$50.8

AU$47.8

AU$45.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$607m

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (1.9%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 7.4%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = AU$92m× (1 + 1.9%) ÷ (7.4%– 1.9%) = AU$1.7b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$1.7b÷ ( 1 + 7.4%)10= AU$836m

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$1.4b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of AU$13.4, the company appears quite good value at a 35% 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.

dcf
dcf

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 McMillan Shakespeare 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 7.4%, which is based on a levered beta of 0.924. 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 McMillan Shakespeare

Strength

  • Earnings growth over the past year exceeded the industry.

  • Debt is not viewed as a risk.

  • Dividend is in the top 25% of dividend payers in the market.

Weakness

  • No major weaknesses identified for MMS.

Opportunity

  • Annual earnings are forecast to grow faster than the Australian market.

  • Good value based on P/E ratio and estimated fair value.

  • Significant insider buying over the past 3 months.

Threat

  • Dividends are not covered by earnings and cashflows.

  • Annual revenue is forecast to grow slower than the Australian market.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or 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. Why is the intrinsic value higher than the current share price? For McMillan Shakespeare, we've put together three relevant elements you should look at:

  1. Risks: As an example, we've found 1 warning sign for McMillan Shakespeare that you need to consider before investing here.

  2. Future Earnings: How does MMS'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 Australian 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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