Estimating the intrinsic value of Mount Gibson Iron Limited (ASX:MGX)

Key findings

• The forecast fair value for Mount Gibson Iron is AU$0.52 based on the dividend discount model

• The current share price of AU$0.42 suggests that Mount Gibson Iron may be trading close to its fair value.

Today we’re going to walk through one way to estimate the intrinsic value of Mount Gibson Iron Limited (ASX:MGX) by taking the expected future cash flows and discounting them to today’s value. To do this, we’re going to use the Discounted Cash Flow (DCF) model. Before you think you can’t understand it, just keep reading! It’s actually a lot less complex than you think.

Companies can be valued in many ways, so we would like to point out that a DCF is not perfect for every situation. For those who enjoy stock analysis, the analysis model from Simply Wall St listed here might be of interest.

Check out our latest analysis for Mount Gibson Iron

What is the estimated value?

Because Mount Gibson Iron operates in the metals and mining sector, we need to calculate intrinsic value a little differently. This approach uses dividends per share (DPS) because free cash flow is difficult to estimate and often unreported by analysts. Unless a company pays out the majority of its free cash flow as dividends, this method will typically underestimate the value of the stock. It uses the ‘Gordon Growth Model’, which simply assumes that dividend payments will continue to grow at a sustainable growth rate forever. For a number of reasons, a very conservative growth rate is used, which cannot exceed that of a company’s gross domestic product (GDP). In this case, we used the 5-year average of the 10-year Treasury bond yield (2.3%). The expected dividend per share is then discounted to today’s value using a cost of equity of 8.3%. Compared to the current share price of AU$0.4, the company appears to be roughly fairly valued at a 20% discount to the current share price. Since the assumptions of a calculation have a big impact on the valuation, it is better to consider it as a rough estimate rather than accurate to the last cent.

Value per share = Expected dividend per share / (Discount rate – Perpetual growth rate)

= 0.07AU$ / (8.3% – 2.3%)

= 0.5AU$

Important assumptions

The key inputs to a discounted cash flow are the discount rate and, of course, the actual cash flows. Part of investing is making your own assessment of a company’s future performance, so try the calculation yourself and check your own assumptions. The DCF also does not take into account the potential cyclicality of an industry or a company’s future capital needs, and therefore does not provide a complete picture of a company’s potential performance. Since we are viewing Mount Gibson Iron 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 8.3%, which is based on a levered beta of 1.315. Beta is a measure of a stock’s volatility relative to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with a set limit of 0.8 to 2.0, which is a reasonable range for a stable company.

The story goes on

Looking ahead:

While the DCF calculation is important, ideally it shouldn’t be the only analysis you look at for a company. It’s not possible to get a foolproof valuation using a DCF model. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to an undervaluation or overvaluation of the company. For example, making a small adjustment to the terminal value growth rate can dramatically change the overall result. For Mount Gibson Iron, we’ve compiled three other elements you should examine in more detail:

1. Financial health: Does MGX have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on important factors such as debt and risk.

2. Future income: How does MGX’s growth rate compare to competitors and the overall market? Learn more about analyst consensus numbers for the coming years by using our free chart of analyst growth expectations.

3. Other high-quality alternatives: Like a good all-rounder? Explore our interactive list of high-quality stocks to get a sense of what else you might be missing out on!

PS The Simply Wall St app runs 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 Simply Wall St article is of a general nature. We comment based solely on historical data and analyst forecasts, using an unbiased methodology. Our articles do not constitute financial advice. It is not a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. Our goal is to provide you with long-term analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative materials. Simply Wall St does not hold any of the stocks mentioned.

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