Calculating The Fair Value Of MTR Corporation Limited (HKG:66)

Simply Wall St.02-02

Key Insights MTR's estimated fair value is HK$30.46 based on 2 Stage Free Cash Flow to Equity With HK$25.25 share price, MTR appears to be trading close to its estimated fair value Our fair value ...

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Today, we will estimate the stock's intrinsic value  by taking the expected future cash flows and discounting them to their present value.  We will use the Discounted Cash Flow (DCF) model on this occasion.  Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.  Remember though, that there are many ways to estimate a company's value, and a DCF is just one method.  If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.  View our latest analysis for MTR  The Model   We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase.  In the first stage we need to estimate the cash flows to the business over the next ten years.   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 companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.   Generally we assume that a dollar today is more valuable 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) estimate  2024 2025 2026 2027 2028 2029 2030 2031 2032 2033  Levered FCF (HK$, Millions)  HK$4.56b HK$995.2m HK$11.4b HK$12.8b HK$14.0b HK$14.9b HK$15.6b HK$16.3b HK$16.9b HK$17.4b Growth Rate Estimate Source Analyst x2 Analyst x2 Analyst x1 Analyst x1 Analyst x1 Est @ 6.47% Est @ 5.12% Est @ 4.17% Est @ 3.51% Est @ 3.05%  Present Value (HK$, Millions) Discounted @ 8.7%  HK$4.2k HK$843 HK$8.9k HK$9.1k HK$9.2k HK$9.0k HK$8.7k HK$8.4k HK$8.0k HK$7.6k (\"Est\" = FCF growth rate estimated by Simply Wall St)Present Value of 10-year Cash Flow (PVCF) = HK$74b After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage.  For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (2.0%) 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 8.7%. Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = HK$17b× (1 + 2.0%) ÷ (8.7%– 2.0%) = HK$265bPresent Value of Terminal Value (PVTV)= TV / (1 + r)10= HK$265b÷ ( 1 + 8.7%)10= HK$115b The total value, or equity value, is then the sum of the present value of the future cash flows,  which in this case is HK$189b.  In the final step we divide the equity value by the number of shares outstanding.  Compared to the current share price of HK$25.3, the company appears   about fair value    at a 17% discount to where the stock price trades currently.   The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent. SEHK:66 Discounted Cash Flow February 1st 2024  The Assumptions  The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows.  You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them.  The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance.  Given that we are looking at MTR 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 accounts for debt.  In this calculation we've used 8.7%, which is based on a levered beta of 1.133. Beta is a measure of a stock's volatility, compared 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.  SWOT Analysis for MTRStrength Debt is well covered by earnings. Balance sheet summary for 66. Weakness Earnings declined over the past year. Dividend is low compared to the top 25% of dividend payers in the Transportation market.Opportunity Annual earnings are forecast to grow faster than the Hong Kong market.  Current share price is below our estimate of fair value. ThreatDebt is not well covered by operating cash flow. Paying a dividend but company has no free cash flows. Annual revenue is forecast to grow slower than the Hong Kong market. Is 66 well equipped to handle threats?  Moving On:  Whilst important, the DCF calculation  is only one of many factors that you need to assess for a company.  It's not possible to obtain a foolproof valuation with a DCF model.  Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation.  If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different.  For MTR, we've put together three  essential  elements  you should further examine:   Risks: As an example, we've found 2 warning signs for MTR that you need to consider before investing here.  Future Earnings: How does 66's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart. Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!   PS. Simply Wall St updates its DCF calculation for every Hong Kong stock every day, so if you want to find the intrinsic value of any other stock just search here.Valuation is complex, but we're helping make it simple.Find out whether MTR is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.View the Free AnalysisHave feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. 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