As part of our process, we perform a rigorous discounted cash-flow methodology that dives into the true intrinsic worth of companies. In MGE Energy's (NASDAQ:MGEE) case, we think the firm is fairly valued at $47, about in line to where it is currently trading.
At Valuentum, we think a comprehensive analysis of a firm's discounted cash-flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index (click here for an in-depth presentation about our methodology), which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below):
If a company is undervalued both on a DCF and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. MGE Energy posts a VBI score of 6 on our scale, reflecting our 'fairly valued' DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. We compare MGE Energy to peers Duke Energy (NYSE:DUK), Exelon (NYSE:EXC), and First Energy (NYSE:FE). In the spirit of transparency, we show how the performance of our VBI has stacked up per underlying score:
Our Report on MGE Energy
• MGE distributes electricity in over 300+ square miles of Dane County, Wisconsin. Electric operations account for roughly 70% of the firm's regulated operations, with coal being the primary source. The firm continues to invest in renewal energy sources and owns wind-powered turbines in Iowa.
• The firm generates a fixed rate of return north of 12% in its MGE Power West Campus and MGE Power Elm Road operations. The firm's Madison Gas and Electric Co. and MGE Transco Investment entity generate double-digit returns, as well.
• MGE Energy has a good combination of strong free cash flow generation and manageable financial leverage. We expect the firm's free cash flow margin to average about 11.8% in coming years. Total debt-to- EBITDA was 2.4 last year, while debt-to-book capitalization stood at 39.8%. The company boasts very attractive ratings from the credit agencies.
• Though MGE boasts a very attractive service area in Madison, the company's operations are concentrated. This exposes the firm to unique regional risks that are not inherent to other more geographically-diverse peers.
• The firm sports a very nice dividend yield of 3%. We expect the firm to pay out about 55% of next year's earnings to shareholders as dividends. It has raised its dividend in each of the past 35+ years.
Economic Profit Analysis
The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital (ROIC) with its weighted average cost of capital (OTC:WACC). The gap or difference between ROIC and WACC is called the firm's economic profit spread. MGE Energy's 3-year historical return on invested capital (without goodwill) is 5.5%, which is below the estimate of its cost of capital of 8.6%. As such, we assign the firm a ValueCreation™ rating of POOR. In the chart below, we show the probable path of ROIC in the years ahead based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.
Cash Flow Analysis
Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. MGE Energy's free cash flow margin has averaged about 10.5% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At MGE Energy, cash flow from operations increased about 11% from levels registered two years ago, while capital expenditures fell about 16% over the same time period.
Our discounted cash flow model indicates that MGE Energy's shares are worth between $38.00 - $56.00 each. The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $47 per share represents a price-to earnings (P/E) ratio of about 17.8 times last year's earnings and an implied EV/EBITDA multiple of about 9.4 times last year's EBITDA. Our model reflects a compound annual revenue growth rate of 1.8% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -2.9%. Our model reflects a 5-year projected average operating margin of 23.8%, which is above MGE Energy's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.1% for the next 15 years and 3% in perpetuity. For MGE Energy, we use a 8.6% weighted average cost of capital to discount future free cash flows.
Margin of Safety Analysis
Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $47 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for MGE Energy. We think the firm is attractive below $38 per share (the green line), but quite expensive above $56 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.
Future Path of Fair Value
We estimate MGE Energy's fair value at this point in time to be about $47 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of MGE Energy's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $57 per share in Year 3 represents our existing fair value per share of $47 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.
Pro Forma Financial Statements
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.