Is There An Opportunity With MTU Aero Engines AG's (ETR:MTX) 50% Undervaluation?

Key Insights

• MTU Aero Engines' estimated fair value is €375 based on 2 Stage Free Cash Flow to Equity

• MTU Aero Engines is estimated to be 50% undervalued based on current share price of €189

• Our fair value estimate is 74% higher than MTU Aero Engines' analyst price target of €216

Does the December share price for MTU Aero Engines AG (ETR:MTX) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by estimating the company's future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

See our latest analysis for MTU Aero Engines

Is MTU Aero Engines 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, 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) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (€, Millions)	€402.3m	€460.9m	€551.5m	€659.8m	€736.6m	€797.8m	€845.2m	€881.5m	€909.3m	€930.6m
Growth Rate Estimate Source	Analyst x10	Analyst x10	Analyst x6	Analyst x4	Est @ 11.66%	Est @ 8.30%	Est @ 5.95%	Est @ 4.30%	Est @ 3.15%	Est @ 2.34%
Present Value (€, Millions) Discounted @ 4.5%	€385	€422	€483	€552	€590	€611	€619	€618	€610	€597

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = €5.5b

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 0.5%. We discount the terminal cash flows to today's value at a cost of equity of 4.5%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = €931m× (1 + 0.5%) ÷ (4.5%– 0.5%) = €23b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= €23b÷ ( 1 + 4.5%)¹⁰= €15b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is €20b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of €189, the company appears quite good value at a 50% 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

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 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 MTU Aero Engines 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 4.5%, which is based on a levered beta of 0.816. 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 MTU Aero Engines

Strength

• Debt is not viewed as a risk.

• Dividends are covered by earnings and cash flows.

Weakness

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

Opportunity

• Expected to breakeven next year.

• Has sufficient cash runway for more than 3 years based on current free cash flows.

• Trading below our estimate of fair value by more than 20%.

Threat

• No apparent threats visible for MTX.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price sitting below the intrinsic value? For MTU Aero Engines, we've put together three further aspects you should look at:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with MTU Aero Engines , and understanding this should be part of your investment process.

2. Future Earnings: How does MTX'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 German 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.