Today we'll do a simple run through of a valuation method used to estimate the attractiveness of SkyCity Entertainment Group Limited (NZSE:SKC) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis 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. To start off with, we need to estimate 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 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.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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 (NZ$, Millions)
-NZ$105.4m
NZ$124.9m
NZ$167.1m
NZ$155.9m
NZ$162.5m
NZ$168.0m
NZ$173.3m
NZ$178.4m
NZ$183.5m
NZ$188.6m
Growth Rate Estimate Source
Analyst x3
Analyst x3
Analyst x3
Analyst x2
Analyst x2
Est @ 3.41%
Est @ 3.15%
Est @ 2.97%
Est @ 2.84%
Est @ 2.76%
Present Value (NZ$, Millions) Discounted @ 8.7%
-NZ$97.0
NZ$106
NZ$130
NZ$112
NZ$107
NZ$102
NZ$96.8
NZ$91.7
NZ$86.8
NZ$82.0
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = NZ$817m
The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.6%. We discount the terminal cash flows to today's value at a cost of equity of 8.7%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= NZ$3.2b÷ ( 1 + 8.7%)10= NZ$1.4b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is NZ$2.2b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of NZ$1.9, the company appears quite good value at a 34% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
NZSE:SKC Discounted Cash Flow February 20th 2024
The Assumptions
We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own assumptions. 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 SkyCity Entertainment 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 accounts for debt. In this calculation we've used 8.7%, which is based on a levered beta of 1.332. 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 SkyCity Entertainment Group
Strength
Debt is not viewed as a risk.
Weakness
Dividend is low compared to the top 25% of dividend payers in the Hospitality market.
Opportunity
Annual earnings are forecast to grow faster than the New Zealander market.
Trading below our estimate of fair value by more than 20%.
Threat
Dividends are not covered by earnings and cashflows.
Annual revenue is forecast to grow slower than the New Zealander market.
Next Steps:
Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Can we work out why the company is trading at a discount to intrinsic value? For SkyCity Entertainment Group, we've compiled three additional aspects you should assess:
Future Earnings: How does SKC'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NZSE every day. If you want to find the calculation for other stocks just search here.
Have 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. Simply Wall St has no position in any stocks mentioned.
