A Look At The Fair Value Of Warner Music Group Corp. (NASDAQ:WMG)

Key Insights

• Warner Music Group's estimated fair value is US$34.58 based on 2 Stage Free Cash Flow to Equity

• Current share price of US$31.03 suggests Warner Music Group is potentially trading close to its fair value

• Our fair value estimate is 8.3% higher than Warner Music Group's analyst price target of US$31.92

Today we will run through one way of estimating the intrinsic value of Warner Music Group Corp. (NASDAQ:WMG) 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. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for Warner Music Group

Is Warner Music Group Fairly Valued?

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 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$721.0m	US$844.8m	US$1.08b	US$1.20b	US$1.28b	US$1.36b	US$1.42b	US$1.47b	US$1.52b	US$1.57b
Growth Rate Estimate Source	Analyst x8	Analyst x6	Analyst x2	Analyst x2	Est @ 7.13%	Est @ 5.63%	Est @ 4.57%	Est @ 3.83%	Est @ 3.32%	Est @ 2.95%
Present Value ($, Millions) Discounted @ 8.8%	US$663	US$713	US$840	US$854	US$840	US$816	US$784	US$748	US$710	US$672

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$7.6b

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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 8.8%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$1.6b× (1 + 2.1%) ÷ (8.8%– 2.1%) = US$24b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$24b÷ ( 1 + 8.8%)¹⁰= US$10b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$18b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of US$31.0, the company appears about fair value at a 10% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

dcf

Important 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 Warner Music 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 8.8%, which is based on a levered beta of 1.131. 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 Warner Music Group

Strength

• Earnings growth over the past year exceeded its 5-year average.

• Debt is well covered by earnings.

• Dividends are covered by earnings and cash flows.

Weakness

• Earnings growth over the past year underperformed the Entertainment industry.

• Dividend is low compared to the top 25% of dividend payers in the Entertainment market.

Opportunity

• Annual earnings are forecast to grow faster than the American market.

• Current share price is below our estimate of fair value.

Threat

• Debt is not well covered by operating cash flow.

• Revenue is forecast to grow slower than 20% per year.

Next Steps:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. 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. For Warner Music Group, we've put together three essential aspects you should assess:

1. Risks: We feel that you should assess the 2 warning signs for Warner Music Group (1 doesn't sit too well with us!) we've flagged before making an investment in the company.

2. Future Earnings: How does WMG'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NASDAQGS 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.

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