Valuing Meridian Water Group with a Two-Stage DCF
Meridian Water Group is a listed utility with 900m shares, net debt of £1.8bn and last reported FCFF of £420m. Analysts expect FCFF to grow 8% a year for five years, then 2.5% in perpetuity. The company's WACC is estimated at 8.5%. The shares trade at £12.40. The company has a £600m defined benefit pension deficit and faces environmental litigation that could cost up to £250m. The finance director argues the market price is justified by 'long-term growth options' and points to a peer group trading at 18x earnings. The investment committee uses a two-stage DCF and wants to know whether the shares are mispriced. A colleague suggests using a 7.5% WACC because 'the risk-free rate has fallen'.
1. Calculate the intrinsic value per share using the two-stage DCF. Show the explicit forecast, terminal value and bridge to equity value.
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FCFF grows at 8% for five years: £453.6m, £489.9m, £529.1m, £571.4m and £617.1m. Discounting at 8.5% gives present values of approximately £418.0m, £416.1m, £414.2m, £412.3m and £410.4m, a total of about £2,071m.
The terminal value at the end of year 5 is FCFF5 × (1 + g) / (WACC - g) = £617.1m × 1.025 / (0.085 - 0.025) = £10,542m. Discounting five years at 8.5% gives about £7,010m. Enterprise value is therefore £2,071m + £7,010m = £9,081m. Deduct net debt of £1,800m to get equity value of £7,281m, or £8.09 per share (900m shares).
The market price of £12.40 is about 53% above this DCF value. If the pension deficit and litigation are treated as debt-like claims, deducting £600m and £250m gives equity value of £6,431m, or £7.15 per share. Even before those deductions, the DCF does not support the market price.
2. Assess the sensitivity of the valuation to WACC and terminal growth, and evaluate the colleague's suggestion of a 7.5% WACC.
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The terminal value is about 77% of enterprise value, so the result is highly sensitive. At a 7.5% WACC and 2.5% terminal growth, the value is about £10.16 per share. At a 9.5% WACC it falls to about £6.62. At 8.5% WACC but 3.5% terminal growth, the value is about £9.74. None of these reasonable sensitivities reaches £12.40.
A reverse DCF shows what the market price requires. Equity value at £12.40 is £11,160m, so enterprise value is £12,960m. After deducting the £2,071m present value of explicit FCFF, the present value of the terminal value must be £10,889m, implying a terminal value of about £16,374m. With an 8.5% WACC, that requires perpetual growth of about 4.6%, well above the 2.5% assumption. Alternatively, holding growth at 2.5%, the implied WACC is only about 6.7%.
The colleague's 7.5% WACC is not a legitimate adjustment unless the risk profile has genuinely changed. Lowering the discount rate simply to justify the market price is circular. If the risk-free rate has fallen, the WACC should be rebuilt from current inputs, not chosen to fit the share price.
3. Discuss the limitations of the DCF and recommend what additional analysis the investment committee should perform before deciding.
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The DCF is a single-scenario valuation with a dominant terminal value and a constant WACC. It does not capture regulatory risk, commodity exposure, environmental liabilities or pension funding volatility. The peer multiple of 18x earnings is not a valuation proof: peers may have different growth, leverage, regulation or accounting. The pension deficit and litigation should be modelled explicitly, with probability weights for the litigation rather than a single maximum cost.
The committee should run a reverse DCF, scenario analysis and a Monte Carlo simulation around growth, WACC and terminal margin. It should compare the implied multiples with peers and the company's own history, and review cash-flow quality, capital expenditure and dividend cover. It should also test whether the 'long-term growth options' are already in the explicit forecast or require additional capital expenditure.
On the current evidence, the shares look expensive. The committee should not buy on the finance director's argument. If the fund already holds the shares, it should consider underweighting them and review the position if the price falls toward the DCF range.