Calculation of the fair value of Houghton Mifflin Harcourt Company (NASDAQ: HMHC)

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Today we’re going to review one way to estimate the intrinsic value of Houghton Mifflin Harcourt Company (NASDAQ: HMHC) by projecting its future cash flows and then discounting them to present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. There really isn’t much to it, although it might seem quite complex.

There are many ways businesses can be assessed, so we would like to point out that a DCF is not perfect for all situations. For those who are passionate about equity analysis, the Simply Wall St analysis template here may be something of interest to you.

See our latest review for Houghton Mifflin Harcourt

The model

We are going to use a two-step DCF model, which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “steady growth”. To begin with, we need to estimate the next ten years of cash flow. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated value. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent years.

In general, we assume that a dollar today is worth more than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today’s dollars:

10-year Free Cash Flow (FCF) estimate

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Leverage FCF ($, Millions) US $ 119.0 million US $ 105.2 million US $ 97.3 million US $ 92.7 million US $ 90.2 million US $ 89.0 million US $ 88.8 million US $ 89.1 million US $ 89.8 million US $ 90.9 million
Source of growth rate estimate Analyst x1 Is @ -11.61% Is @ -7.54% Is @ -4.69% East @ -2.69% Is @ -1.3% East @ -0.32% Is @ 0.36% Is @ 0.84% Est @ 1.18%
Present value (in millions of dollars) discounted at 5.9% 112 USD US $ 93.7 $ 81.8 US $ 73.6 US $ 67.6 US $ 63.0 $ 59.3 US $ 56.2 US $ 53.5 US $ 51.1

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 712 million

We now need to calculate the Terminal Value, which takes into account all future cash flows after this ten year period. The Gordon growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.0%. We discount the terminal cash flows to their present value at a cost of equity of 5.9%.

Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US $ 91 million × (1 + 2.0%) ÷ (5.9% – 2.0%) = US $ 2.3 billion

Present value of terminal value (PVTV)= TV / (1 + r)ten= US $ 2.3 billion ÷ (1 + 5.9%)ten= US $ 1.3 billion

Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is $ 2.0 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of $ 17.3, the company appears to be around fair value at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it’s best to take this as a rough estimate, not precise down to the last penny.

NasdaqGS: HMHC Discounted Cash Flows November 6, 2021

Important assumptions

Now the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. If you don’t agree with these results, try the calculation yourself and play with the assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a full picture of a company’s potential performance. Since we consider Houghton Mifflin Harcourt to be a potential shareholder, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which takes debt into account. In this calculation, we used 5.9%, which is based on a leveraged beta of 0.906. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

To move on :

While important, calculating DCF shouldn’t be the only metric you look at when looking for a business. DCF models are not the ultimate solution for investment valuation. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. For Houghton Mifflin Harcourt, there are three other things you should research further:

  1. Risks: Take risks, for example – Houghton Mifflin Harcourt a 3 warning signs (and 1 which doesn’t suit us very well) we think you should be aware of.
  2. Future benefits: How does HMHC’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus number for years to come by interacting with our free analyst growth expectations chart.
  3. Other strong companies: 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 trading fundamentals to see if there are other companies you may not have considered!

PS. Simply Wall St updates its DCF calculation for every US stock every day, so if you want to find the intrinsic value of any other stock just search here.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in any of the stocks mentioned.

Do you have any feedback on this item? Are you worried about the content? Get in touch with us directly. You can also send an email to the editorial team (at) simplywallst.com.

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