Calculating The Intrinsic Value Of Methode Electronics, Inc. (NYSE:MEI)
Key Insights
Methode Electronics' estimated fair value is US$18.43 based on 2 Stage Free Cash Flow to Equity
Current share price of US$21.60 suggests Methode Electronics is potentially trading close to its fair value
The US$28.50 analyst price target for MEI is 55% more than our estimate of fair value
In this article we are going to estimate the intrinsic value of Methode Electronics, Inc. (NYSE:MEI) by taking the forecast future cash flows of the company and discounting them back to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
Check out our latest analysis for Methode Electronics
Is Methode Electronics Fairly Valued?
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To begin with, we have to get estimates of the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) forecast
2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | 2033 | |
Levered FCF ($, Millions) | -US$23.3m | US$50.5m | US$50.1m | US$50.2m | US$50.6m | US$51.2m | US$52.0m | US$53.0m | US$54.0m | US$55.1m |
Growth Rate Estimate Source | Analyst x2 | Analyst x1 | Est @ -0.76% | Est @ 0.15% | Est @ 0.79% | Est @ 1.24% | Est @ 1.56% | Est @ 1.78% | Est @ 1.93% | Est @ 2.04% |
Present Value ($, Millions) Discounted @ 8.6% | -US$21.5 | US$42.8 | US$39.1 | US$36.1 | US$33.5 | US$31.2 | US$29.2 | US$27.3 | US$25.6 | US$24.1 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$267m
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 2.3%. We discount the terminal cash flows to today's value at a cost of equity of 8.6%.
Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$55m× (1 + 2.3%) ÷ (8.6%– 2.3%) = US$889m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$889m÷ ( 1 + 8.6%)10= US$389m
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$656m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of US$21.6, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
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 Methode Electronics 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 8.6%, which is based on a levered beta of 1.377. 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 Methode Electronics
Strength
Debt is not viewed as a risk.
Weakness
Dividend is low compared to the top 25% of dividend payers in the Electronic market.
Expensive based on P/S ratio and estimated fair value.
Opportunity
Forecast to reduce losses next year.
Has sufficient cash runway for more than 3 years based on current free cash flows.
Threat
Paying a dividend but company is unprofitable.
Not expected to become profitable over the next 3 years.
Next Steps:
Although the valuation of a company is important, it 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. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Methode Electronics, we've compiled three essential factors you should explore:
Risks: You should be aware of the 1 warning sign for Methode Electronics we've uncovered before considering an investment in the company.
Future Earnings: How does MEI'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 Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NYSE every day. If you want to find the calculation for other stocks just search here.
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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.
