Meridian Energy Limited (NZSE:MEL) Shares Could Be 42% Below Their Intrinsic Value Estimate

Key Insights

• The projected fair value for Meridian Energy is NZ$8.53 based on 2 Stage Free Cash Flow to Equity

• Meridian Energy is estimated to be 42% undervalued based on current share price of NZ$4.96

• The NZ$5.31 analyst price target for MEL is 38% less than our estimate of fair value

In this article we are going to estimate the intrinsic value of Meridian Energy Limited (NZSE:MEL) by taking the forecast future cash flows of the company and discounting them back to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. It may sound complicated, but actually it is quite simple!

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. 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 Meridian Energy

The Model

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, 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$487.5m	NZ$508.5m	NZ$629.5m	NZ$654.0m	NZ$832.0m	NZ$926.4m	NZ$1.01b	NZ$1.08b	NZ$1.13b	NZ$1.19b
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x2	Analyst x1	Analyst x1	Est @ 11.35%	Est @ 8.67%	Est @ 6.80%	Est @ 5.49%	Est @ 4.57%
Present Value (NZ$, Millions) Discounted @ 6.4%	NZ$458	NZ$449	NZ$522	NZ$510	NZ$609	NZ$637	NZ$651	NZ$653	NZ$647	NZ$636

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NZ$5.8b

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 (2.4%) 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 6.4%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = NZ$1.2b× (1 + 2.4%) ÷ (6.4%– 2.4%) = NZ$30b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= NZ$30b÷ ( 1 + 6.4%)¹⁰= NZ$16b

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$22b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of NZ$5.0, the company appears quite good value at a 42% 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

The Assumptions

Now 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 Meridian Energy 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 6.4%, which is based on a levered beta of 0.800. 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 Meridian Energy

Strength

• Debt is not viewed as a risk.

Weakness

• Earnings declined over the past year.

• Dividend is low compared to the top 25% of dividend payers in the Renewable Energy 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.

Looking Ahead:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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. What is the reason for the share price sitting below the intrinsic value? For Meridian Energy, there are three pertinent items you should explore:

1. Risks: For example, we've discovered 2 warning signs for Meridian Energy (1 is potentially serious!) that you should be aware of before investing here.

2. Future Earnings: How does MEL'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 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. Simply Wall St updates its DCF calculation for every New Zealander stock every day, so if you want to find the intrinsic value of any other stock 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.