The intrinsic value of Midwich Group plc (LON:MIDW) is potentially 69% higher than its share price
How far is Midwich Group plc (LON:MIDW) from its intrinsic value? Using the most recent financial data, we will examine whether the stock price is fair by taking the expected future cash flows and discounting them to the present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. There really isn’t much to do, although it may seem quite complex.
We draw your attention to the fact that there are many ways to value a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. For those who are passionate about stock analysis, the Simply Wall St analysis template here may interest you.
See our latest analysis for Midwich Group
We use the 2-stage growth model, which simply means that we consider two stages of business growth. In the initial period, the company may have a higher growth rate, and the second stage is generally assumed to have a stable growth rate. In the first step, we need to estimate the company’s cash flow over the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported 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 more in early years than in later years.
Generally, we assume that a dollar today is worth more than a dollar in the future, and so the sum of these future cash flows is then discounted to today’s value:
10-Year Free Cash Flow (FCF) Forecast
|Leveraged FCF (£, millions)||UK£13.3m||UK£28.8m||UK£36.6m||UK£42.3m||UK£47.0m||UK£50.8m||UK£53.9m||UK£56.2m||UK£58.1m||UK£59.6m|
|Growth rate estimate Source||Analyst x3||Analyst x3||Analyst x2||Is at 15.59%||Is at 11.18%||Is at 8.09%||Is at 5.93%||Is at 4.41%||Is at 3.35%||Is at 2.61%|
|Present value (£, million) discounted at 6.5%||UK£12.5||UK£25.4||UK£30.3||UK£32.8||UK£34.3||UK£34.8||UK£34.6||UK£33.9||UK£32.8||UK£31.6|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = UK £302 million
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 stage. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 0.9%. We discount terminal cash flows to present value at a cost of equity of 6.5%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = UK£60m × (1 + 0.9%) ÷ (6.5%– 0.9%) = UK£1.1b
Present value of terminal value (PVTV)= TV / (1 + r)ten= UK£1.1b÷ ( 1 + 6.5%)ten= UK £563 million
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is £865 million. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of £5.8 in the UK, the company appears to be pretty good value at a 41% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.
We emphasize that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. If you disagree with these results, try the math yourself and play around with the assumptions. 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 Midwich Group 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 debt into account. In this calculation, we used 6.5%, which is based on a leveraged beta of 1.170. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Valuation is only one side of the coin in terms of building your investment thesis, and it’s just one of many factors you need to assess for a company. The DCF model is not a perfect stock 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 company grows at a different pace, or if its cost of equity or risk-free rate changes sharply, output may be very different. Can we understand why the company is trading at a discount to its intrinsic value? For Midwich Group, we’ve compiled three essential factors you should explore:
- Risks: Every business has them, and we’ve spotted 2 warning signs for Midwich Group (1 of which is potentially serious!) that you should know about.
- Future earnings: How does MIDW’s growth rate compare to its peers and the wider market? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
- Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of what you might be missing!
PS. The Simply Wall St app performs an updated cash flow valuation for every stock on AIM every day. If you want to find the calculation for other stocks, 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 only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.