Mercury NZ Limited (NZSE:MCY)’s intrinsic value may be 53% above its share price

Key findings

• Using the 2-step free cash flow to equity, the fair value of Mercury NZ is NZ$10.01
• Mercury NZ is estimated to be 34% undervalued based on the current share price of NZ$6.57.
• The analyst price target of NZ$6.64 for MCY is 34% below our fair value estimate

How far is Mercury NZ Limited (NZSE:MCY) from its intrinsic value? Using the most recent financial data, we will check whether the stock is fairly valued by estimating the company’s future cash flows and discounting them to their present value. To do this, we will use the Discounted Cash Flow (DCF) model. There’s actually not too much involved in it, even though it may seem quite complex.

However, keep in mind that there are many ways to estimate the value of a company, and a DCF is just one of them. If you want to learn more about intrinsic value, you should check out Simply Wall St’s analysis model.

Check out our latest analysis for Mercury NZ

Step by step through the calculation

We use a two-stage DCF model which, as the name suggests, considers two phases of growth. The first stage is generally a higher growth phase that stabilizes toward the terminal value captured in the second “steady growth” stage. First, we need to obtain estimates of the next ten years of cash flows. Where possible, we use analyst estimates, but when these aren’t available, we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume that companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will slow their growth rate over this period. We do this to take into account that growth tends to slow more in the early years than in later years.

In general, we assume that a dollar today is worth more than a dollar in the future. Therefore, the sum of these future cash flows is discounted to today’s value:

10-year free cash flow (FCF) forecast

(“Est” = FCF growth rate, estimated by Simply Wall St)
Present value of 10-year cash flow (PVCF) = NZ$3.8 billion

We now need to calculate the terminal value that takes into account all future cash flows after this ten-year period. For various reasons, a very conservative growth rate is used that cannot exceed a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (2.7%) to estimate future growth. In the same way as with the 10-year “growth” period, we discount future cash flows to today’s value, using a cost of equity of 6.4%.

Final value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = NZ$676 million × (1 + 2.7%) ÷ (6.4% – 2.7%) = NZ$19 billion

Present value of terminal value (PVTV)= TV / (1 + r)¹⁰= NZ$19 billion ÷ ( 1 + 6.4 %)¹⁰= NZ$10 billion

The total value or equity value is then the sum of the present value of future cash flows, which in this case is NZ$14 billion. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of NZ$6.6, the company appears quite valuable at a 34% discount to the current share price. The assumptions in any calculation have a big impact on the valuation, so it is better to consider this as a rough estimate that is not accurate to the last cent.

Important assumptions

We would like to point out that the key 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 calculation yourself and play with the assumptions. The DCF also does not take into account the possible 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 consider Mercury NZ 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 have used 6.4%, which is based on a leveraged beta of 0.800. Beta is a measure of a stock’s volatility relative to the overall market. We get our beta from the industry average beta of globally comparable companies with an imposed limit of between 0.8 and 2.0, which is a reasonable range for a stable company.

SWOT Analysis for Mercury NZ

Next Steps:

Although important, ideally the DCF calculation should not be the only analysis you look at for a company. The DCF model is not a perfect stock valuation tool. Rather, it should be viewed as a guide to “what assumptions need to hold for this stock to be under/overvalued”. If a company grows at a different rate, or if its cost of equity or risk-free rate changes significantly, the outcome may look very different. What is the reason for the share price to be below intrinsic value? For Mercury NZ, we have compiled three relevant factors for you to consider:

1. Risks: Note that Mercury NZ shows 3 warning signals in our investment analysis you should know about…
2. Future income: How does MCY’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 Simply Wall St updates its DCF calculation for each New Zealand stock daily, so if you want to find out the intrinsic value of another stock, just search here.

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This Simply Wall St article is of a general nature. We comment 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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