Today we are going to review a valuation method used to estimate the attractiveness of Methode Electronics, Inc. (NYSE: MEI) as an investment opportunity by taking expected future cash flows and determining them. discounting to today’s value. One way to do this is to use the Discounted Cash Flow (DCF) model. It may sound complicated, but it’s actually quite simple!

There are many ways that businesses can be assessed, so we would like to stress that a DCF is not perfect for all situations. If you still have burning questions about this type of valuation, take a look at the Simply Wall St.

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”. In the first step, we need to estimate the cash flow of the business over 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 stated value. 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.

In general, 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 flows (PVCF) = US $ 1.2 billion

The second stage is also known as terminal value, this is the cash flow of the business after the first stage. For a number of reasons, a very conservative growth rate is used which 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 (2.0%) 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 7.4%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = US $ 208 million × (1 + 2.0%) ÷ (7.4% to 2.0%) = US $ 3.9 billion

Present value of terminal value (PVTV)= TV / (1 + r)^ten= US $ 3.9 billion ÷ (1 + 7.4%)^ten= US $ 1.9 billion

The total value is the sum of the cash flows for the next ten years plus the final present value, which gives the total value of equity, which in this case is US $ 3.1 billion. In the last step, we divide the equity value by the number of shares outstanding. From the current share price of US $ 42.1, the company appears to be quite undervalued with a 49% 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.

NYSE: MEI Discounted Cash Flow November 1, 2021

Important assumptions

We draw your attention to the fact that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play 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 Methode Electronics 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 takes into account debt. In this calculation, we used 7.4%, which is based on a leveraged beta of 1.242. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

Looking forward:

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 business. The DCF model is not a perfect equity valuation tool. 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. Can we understand why the company trades at a discount to its intrinsic value? For Methode Electronics, we have put together three relevant things that you need to assess:

1. Risks: For example, we discovered 1 warning sign for Methode Electronics which you should know before investing here.
2. Management: Have insiders increased their stocks to take advantage of market sentiment about MEI’s future prospects? Check out our management and board analysis with information on CEO compensation and governance factors.
3. 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!

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

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 shares 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 the mentioned stocks.

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