Estimate of the intrinsic value of WMG Holdings Bhd. (KLSE: WMG)
Today we are going to review a valuation method used to estimate the attractiveness of WMG Holdings Bhd. (KLSE: WMG) as an investment opportunity by projecting its future cash flows and then discounting them to present value. One way to do this is to use the Discounted Cash Flow (DCF) model. Don’t be put off by the lingo, the underlying calculations are actually pretty straightforward.
There are many ways that businesses can be assessed, so we would like to point out that a DCF is not perfect for all situations. If you are interested in knowing more about discounted cash flow, the rationale for this calculation can be read in detail in the Simply Wall St.
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Crunch the numbers
We are going to use a two-step DCF model, which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “steady growth”. To begin with, we need to get cash flow estimates for the next ten years. Since no free cash flow analyst estimate is available, we have extrapolated the previous free cash flow (FCF) from the last reported value of the company. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we need to discount the sum of these future cash flows to arrive at an estimate of the present value:
10-year Free Cash Flow (FCF) estimate
|Leverage FCF (MYR, Millions)||RM3.97m||RM5.48m||RM 6.98||RM8.41m||RM9.70m||RM10.8m||RM11.9m||RM12.8m||RM13.6 m||RM14.3 million|
|Source of estimated growth rate||Is 52.52%||Est @ 37.84%||Is at 27.56%||East @ 20.37%||Est @ 15.34%||Est @ 11.81%||East @ 9.35%||Est @ 7.62%||Est @ 6.41%||East @ 5.56%|
|Present value (MYR, millions) discounted at 14%||RM3.5||RM4.2||RM4.7||RM4.9||RM5.0||RM4.8||RM4.6||RM4.4||RM4.1||RM3.7|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = RM43m
After calculating the present value of future cash flows over the initial 10 year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first step. 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 used the 5-year average of the 10-year government bond yield (3.6%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to their present value, using a cost of equity of 14%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = RM14m × (1 + 3.6%) ÷ (14% – 3.6%) = RM138m
Present value of terminal value (PVTV)= TV / (1 + r)ten= RM138m ÷ (1 + 14%)ten= RM36m
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total value of equity, which in this case is RM79 million. The last step is then to divide the equity value by the number of shares outstanding. Compared to the current share price of RM 0.1, the company appears around fair value at the time of writing. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.
Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play around with them. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a full picture of a company’s potential performance. Since we view WMG Holdings Bhd as a potential shareholder, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which takes debt into account. In this calculation, we used 14%, which is based on a leveraged beta of 2,000. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our beta from the industry average beta from globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
While valuing a business is important, it’s just one of the many factors you need to assess for a business. DCF models are not the ultimate solution for investment valuation. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. For WMG Holdings Bhd, we’ve compiled three fundamental factors that you should take a closer look at:
- Risks: We think you should evaluate the 1 warning sign for WMG Holdings Bhd we reported before making an investment in the business.
- Other strong companies: 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 trading fundamentals to see if there are other companies you may not have considered!
- Other environmentally friendly companies: Are you concerned about the environment and think that consumers will buy more and more environmentally friendly products? Browse our interactive list of companies thinking about a greener future to discover stocks you might not have thought of!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for each KLSE share. If you want to find the calculation for other actions, just search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only 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 into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.