Are Investors Undervaluing The Star Entertainment Group Limited (ASX:SGR) By 35%?

Key Insights

• Star Entertainment Group's estimated fair value is AU$0.87 based on 2 Stage Free Cash Flow to Equity

• Star Entertainment Group's AU$0.56 share price signals that it might be 35% undervalued

• Analyst price target for SGR is AU$0.92, which is 6.2% above our fair value estimate

Today we will run through one way of estimating the intrinsic value of The Star Entertainment Group Limited (ASX:SGR) by taking the expected future cash flows and discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. 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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Star Entertainment Group

What's The Estimated Valuation?

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	AU$113.0m	AU$11.0m	AU$149.0m	AU$155.1m	AU$172.5m	AU$185.3m	AU$196.1m	AU$205.3m	AU$213.3m	AU$220.5m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Analyst x2	Analyst x2	Analyst x2	Est @ 7.43%	Est @ 5.83%	Est @ 4.70%	Est @ 3.92%	Est @ 3.36%
Present Value (A$, Millions) Discounted @ 8.6%	AU$104	AU$9.3	AU$116	AU$111	AU$114	AU$113	AU$110	AU$106	AU$101	AU$96.4

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$981m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (2.1%) 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 8.6%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$220m× (1 + 2.1%) ÷ (8.6%– 2.1%) = AU$3.4b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$3.4b÷ ( 1 + 8.6%)¹⁰= AU$1.5b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$2.5b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of AU$0.6, the company appears quite good value at a 35% 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.

dcf

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Star 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 8.6%, which is based on a levered beta of 1.308. 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 Star Entertainment Group

Strength

• Net debt to equity ratio below 40%.

Weakness

• Interest payments on debt are not well covered.

• Shareholders have been diluted in the past year.

Opportunity

• Forecast to reduce losses next year.

• Good value based on P/S ratio and estimated fair value.

• Significant insider buying over the past 3 months.

Threat

• Debt is not well covered by operating cash flow.

• Has less than 3 years of cash runway based on current free cash flow.

• Revenue is forecast to decrease over the next 2 years.

Looking Ahead:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true 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 sharply, the output can look very different. Can we work out why the company is trading at a discount to intrinsic value? For Star Entertainment Group, we've compiled three essential elements you should explore:

1. Risks: Take risks, for example - Star Entertainment Group has 2 warning signs (and 1 which doesn't sit too well with us) we think you should know about.

2. Future Earnings: How does SGR'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.

3. 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 Australian stock every day, so if you want to find the intrinsic value of any other stock 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.