U.S. Markets closed

Is There An Opportunity With Micro Focus International plc’s (LON:MCRO) 41.78% Undervaluation?

Does the share price for Micro Focus International plc (LON:MCRO) reflect it’s really worth? Today, I will calculate the stock’s intrinsic value by taking the expected future cash flows and discounting them to today’s value. This is done using the Discounted Cash Flows (DCF) model. It may sound complicated, but actually it is quite simple! 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 August 2018 then I highly recommend you check out the latest calculation for Micro Focus International by following the link below.

The calculation

I use what is known as a 2-stage model, which simply means we have two different periods of varying growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a more stable growth phase. To start off with we need to estimate the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. 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

 2018 2019 2020 2021 2022 Levered FCF (\$, Millions) \$522.33 \$694.98 \$837.18 \$979.49 \$1.14k Source Analyst x3 Analyst x5 Analyst x4 Est @ 17%, capped from 39.64% Est @ 16%, capped from 39.64% Present Value Discounted @ 9.32% \$477.79 \$581.51 \$640.75 \$685.75 \$727.64

Present Value of 5-year Cash Flow (PVCF)= US\$3.11b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after the five years. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (1.4%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 9.3%.

Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = US\$1.14b × (1 + 1.4%) ÷ (9.3% – 1.4%) = US\$14.54b

Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = US\$14.54b ÷ ( 1 + 9.3%)5 = US\$9.31b

The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is US\$12.42b. The last step is to then 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) then we use the equivalent number. This results in an intrinsic value in the company’s reported currency of \$28.46. However, MCRO’s primary listing is in United Kingdom, and 1 share of MCRO in USD represents 0.778 ( USD/ GBP) share of LSE:MCRO, so the intrinsic value per share in GBP is £22.14. Relative to the current share price of £12.89, the stock is quite good value at a 41.8% discount to what it is available for right now.

Important assumptions

I’d like to point out that 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 Micro Focus International 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 9.3%, which is based on a levered beta of 0.921. 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:

Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For MCRO, I’ve put together three important factors you should further research:

1. Financial Health: Does MCRO 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.
2. Future Earnings: How does MCRO’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: Are there other high quality stocks you could be holding instead of MCRO? 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 GB 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.