Calculating The Fair Value Of Houghton Mifflin Harcourt Company (NASDAQ:HMHC)

Does the share price for Houghton Mifflin Harcourt Company (NASDAQ:HMHC) reflect it’s really worth? Today, I will calculate the stock’s intrinsic value by projecting its future cash flows and then discounting them to today’s value. I will use 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. Please also note that this article was written in June 2018 so be sure check out the updated calculation by following the link below. Check out our latest analysis for Houghton Mifflin Harcourt

The method

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 begin with we have to get estimates of the next five years of cash flows. Where possible I use analyst estimates, but when these aren’t available I have extrapolated the previous free cash flow (FCF) from the year before. For this growth rate I used the average annual growth rate over the past five years, but capped at a reasonable level. 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 estimate

2018	2019	2020	2021	2022
Levered FCF ($, Millions)	$-35.35	$91.83	$107.05	$139.70	$140.86
Source	Analyst x2	Analyst x3	Analyst x2	Analyst x1	Extrapolated @ (0.83%)
Present Value Discounted @ 12.53%	$-31.41	$72.52	$75.13	$87.13	$78.07

Present Value of 5-year Cash Flow (PVCF)= US$281.44m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after the five years. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 2.9%. We discount this to today’s value at a cost of equity of 12.5%.

Terminal Value (TV) = FCF₂₀₂₂ × (1 + g) ÷ (r – g) = US$140.86m × (1 + 2.9%) ÷ (12.5% – 2.9%) = US$1.51b

Present Value of Terminal Value (PVTV) = TV / (1 + r)⁵ = US$1.51b ÷ ( 1 + 12.5%)⁵ = US$839.15m

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$1.12b. In the final step we 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) or ADR then we use the equivalent number. This results in an intrinsic value of $9.08. Compared to the current share price of $7.9, the stock is about right, perhaps slightly undervalued at a 13.01% discount to what it is available for right now.

NasdaqGS:HMHC Intrinsic Value June 25th 18

The 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 my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at Houghton Mifflin Harcourt 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 12.5%, which is based on a levered beta of 1.359. 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:

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. For HMHC, there are three essential factors you should look at:

1. Financial Health: Does HMHC 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 HMHC’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 HMHC? 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 US stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.

To help readers see pass 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.