Are Investors Undervaluing MotorCycle Holdings Limited (ASX:MTO) By 41%?

Key Insights

• MotorCycle Holdings' estimated fair value is AU$2.09 based on 2 Stage Free Cash Flow to Equity

• MotorCycle Holdings' AU$1.23 share price signals that it might be 41% undervalued

• Our fair value estimate is 15% higher than MotorCycle Holdings' analyst price target of AU$1.82

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of MotorCycle Holdings Limited (ASX:MTO) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

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. 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.

Check out our latest analysis for MotorCycle Holdings

Is MotorCycle Holdings Fairly Valued?

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 begin with, we have to get estimates of 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) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	AU$14.7m	AU$15.4m	AU$14.7m	AU$14.4m	AU$14.2m	AU$14.2m	AU$14.3m	AU$14.5m	AU$14.7m	AU$15.0m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x2	Est @ -2.32%	Est @ -0.95%	Est @ 0.02%	Est @ 0.69%	Est @ 1.16%	Est @ 1.49%	Est @ 1.72%
Present Value (A$, Millions) Discounted @ 11%	AU$13.2	AU$12.6	AU$10.9	AU$9.6	AU$8.6	AU$7.8	AU$7.1	AU$6.5	AU$5.9	AU$5.4

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$88m

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. 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 (2.3%) 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 11%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$15m× (1 + 2.3%) ÷ (11%– 2.3%) = AU$183m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$183m÷ ( 1 + 11%)¹⁰= AU$67m

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$154m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of AU$1.2, the company appears quite undervalued at a 41% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf

Important Assumptions

Now 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 MotorCycle 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 11%, which is based on a levered beta of 1.819. 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 MotorCycle Holdings

Strength

• Debt is well covered by earnings and cashflows.

• Dividends are covered by earnings and cash flows.

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

Weakness

• Earnings declined over the past year.

Opportunity

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

Threat

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

Moving On:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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. Can we work out why the company is trading at a discount to intrinsic value? For MotorCycle Holdings, there are three further factors you should explore:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 4 warning signs with MotorCycle Holdings (at least 1 which can't be ignored) , and understanding these should be part of your investment process.

2. Future Earnings: How does MTO'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the ASX every day. If you want to find the calculation for other stocks 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.