Does the May Melco Resorts & Entertainment Limited (NASDAQ: MLCO) share price reflect what it is really worth? Today, we’re going to estimate the intrinsic value of the stock by estimating the company’s future cash flows and discounting them to their 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 math is actually pretty straightforward.

There are many ways that businesses can be valued, so we would like to stress that a DCF is not perfect for all situations. For those who are learning equity analysis in depth, the Simply Wall St analysis template here may be of interest to you.

Check out our latest analysis for Melco Resorts & Entertainment

The method

We use what is called a 2-step model, which simply means that we have two different periods of growth rate for the cash flow of the business. Usually the first stage is higher growth and the second stage is lower growth stage. To begin with, we need to get cash flow estimates for the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or the last reported value. We assume that companies with decreasing free cash flow will slow their withdrawal rate, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect that growth tends to slow down more in the early years than in the later years.

Typically, we assume that a dollar today is worth more than a dollar in the future, 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

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flow (PVCF) = $ 6.7 billion

Now we need to calculate the terminal value, which takes into account all future cash flows after that ten year period. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.0%. We discount terminal cash flows to their present value at a cost of equity of 11%.

Terminal value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = $ 1.9 billion × (1 + 2.0%) ÷ (11% – 2.0%) = $ 23 billion

Present value of terminal value (PVTV)= TV / (1 + r)^ten= 23 billion USD ÷ (1 + 11%)^ten= 8.2 billion USD

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 US $ 15 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of US $ 17.3, the company appears to be good value for money with a 45% discount from the current share price. The assumptions in any calculation have a big impact on the valuation, so it’s best to take this as a rough estimate, not precise down to the last penny.

The hypotheses

The above calculation is very dependent on two assumptions. One is the discount rate and the other is cash flow. You don’t have to agree with these entries, I recommend that you redo the math yourself and play around with it. 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 complete picture of a company’s potential performance. Since we view Melco Resorts & Entertainment 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 represents debt. In this calculation, we used 11%, which is based on a leveraged beta of 1.627. 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 of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

To move on:

Valuation is only one side of the coin in terms of building your investment thesis, and it’s just one of the many factors you need to evaluate for a business. DCF models are not the alpha and omega of investment valuation. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. What is the reason why the stock price is lower than intrinsic value? For Melco Resorts & Entertainment, we have compiled three important aspects that you should take a closer look at:

1. Risks: To this end, you should inquire about the 2 warning signs we spotted with Melco Resorts & Entertainment (including 1 which is a bit disturbing).
2. Future income: How does MLCO’s growth rate compare to its peers and to the market in general? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth forecast chart.
3. Other strong companies: Low debt, high returns on equity, and good past performance are essential 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!

PS. The Simply Wall St app performs a daily discounted cash flow assessment for each NASDAQGS share. If you want to find the calculation for other actions, just search here.

Promoted
If you are looking to trade Melco Resorts & Entertainment, open an account with the cheapest * professional approved platform, Interactive Brokers. Their clients from more than 200 countries and territories trade stocks, options, futures, currencies, bonds and funds around the world from a single integrated account.

This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take into account your goals or your financial situation. We aim 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 information. Simply Wall St has no position in any of the stocks mentioned.
^*Interactive Brokers Ranked Least Expensive Broker By StockBrokers.com Annual Online Review 2020

Do you have any comments on this article? Concerned about the content? Get in touch with us directly. You can also send an email to the editorial team (at) simplywallst.com.