Estimating The Fair Value Of Magic Software Enterprises Ltd (NASDAQ:MGIC)
Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of Magic Software Enterprises Ltd (NASDAQ:MGIC) as an investment opportunity by taking the expected future cash flows and discounting them to today’s value. I will use the Discounted Cash Flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. If you are reading this and its not October 2018 then I highly recommend you check out the latest calculation for Magic Software Enterprises by following the link below.
See our latest analysis for Magic Software Enterprises
The method
I’m using the 2-stage growth model, which simply means we take in account two stages of company’s growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have perpetual stable growth rate. To start off with we need to estimate the next five years of cash flows. I then discount this to its value today and sum up the total to get the present value of these cash flows.
5-year cash flow forecast
2019 | 2020 | 2021 | 2022 | 2023 | |
Levered FCF ($, Millions) | $27.92 | $31.81 | $36.24 | $41.29 | $47.03 |
Source | Est @ 13.92% | Est @ 13.92% | Est @ 13.92% | Est @ 13.92% | Est @ 13.92% |
Present Value Discounted @ 11.39% | $25.07 | $25.64 | $26.22 | $26.82 | $27.42 |
Present Value of 5-year Cash Flow (PVCF)= US$131m
After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 2.9%. We discount this to today’s value at a cost of equity of 11.4%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = US$47m × (1 + 2.9%) ÷ (11.4% – 2.9%) = US$574m
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = US$574m ÷ ( 1 + 11.4%)5 = US$334m
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is US$466m. In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number. This results in an intrinsic value of $9.55. Compared to the current share price of $8.53, the stock is about right, perhaps slightly undervalued at a 11% discount to what it is available for right now.
Important assumptions
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. You don’t have to agree with my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at Magic Software Enterprises as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 11.4%, which is based on a levered beta of 1.197. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Next Steps:
Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn’t be the only metric you look at when researching a company. For MGIC, I’ve compiled three essential factors you should further examine:
Financial Health: Does MGIC have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
Future Earnings: How does MGIC’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: Are there other high quality stocks you could be holding instead of MGIC? 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 does a DCF calculation for every US stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.
