Is There An Opportunity With Meridian Energy Limited's (NZSE:MEL) 39% Undervaluation?

Key Insights

• Meridian Energy's estimated fair value is NZ$9.72 based on 2 Stage Free Cash Flow to Equity

• Meridian Energy is estimated to be 39% undervalued based on current share price of NZ$5.92

• Our fair value estimate is 78% higher than Meridian Energy's analyst price target of NZ$5.45

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Meridian Energy Limited (NZSE:MEL) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back 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.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

See our latest analysis for Meridian Energy

Crunching The Numbers

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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, 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$546.5m	NZ$488.0m	NZ$638.5m	NZ$673.0m	NZ$850.0m	NZ$957.1m	NZ$1.05b	NZ$1.13b	NZ$1.19b	NZ$1.25b
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x2	Analyst x1	Analyst x1	Est @ 12.61%	Est @ 9.59%	Est @ 7.48%	Est @ 6.00%	Est @ 4.96%
Present Value (NZ$, Millions) Discounted @ 6.2%	NZ$514	NZ$432	NZ$533	NZ$528	NZ$628	NZ$666	NZ$687	NZ$695	NZ$694	NZ$685

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NZ$6.1b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 (2.6%) 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 6.2%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = NZ$1.3b× (1 + 2.6%) ÷ (6.2%– 2.6%) = NZ$35b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= NZ$35b÷ ( 1 + 6.2%)¹⁰= NZ$19b

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 NZ$25b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of NZ$5.9, the company appears quite undervalued at a 39% 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

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 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 6.2%, 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 well covered by cash flow.

Weakness

• Earnings declined over the past year.

• Interest payments on debt are not well covered.

• 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 expected to decline over the next 3 years.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. 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. Why is the intrinsic value higher than the current share price? For Meridian Energy, we've put together three additional elements you should assess:

1. Risks: As an example, we've found 2 warning signs for Meridian Energy (1 is concerning!) that you need to consider before investing here.

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for MEL's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

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 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.