Currently, Discovery Class A (NASDAQ:DISCA) stock and Class C (NASDAQ:DISCK) stock (but not the Class B (NASDAQ:DISCB)) look very undervalued, given the company’s huge free cash flow (FCF). In fact, there is now a wide gulf in the Discovery stock shares. Class A and C shares trade at $36.37 and $31.20 respectively, versus Class B shares, which trade for $83.85 as of Apr. 19. The obvious conclusion is to buy the Class C shares, which are the cheapest.
One reason for this drastic price difference may be that Class B shares have 10 votes per share, whereas Class A has one vote and Class C shares have zero votes.
However, Discovery is still controlled by the Newhouse family, which has nearly 24% voting power (Page 84). So, it doesn’t really matter how many votes an individual shareholder owns. Therefore, it makes sense to buy the cheapest Discovery stock, Class C shares.
Discovery Stock and the Hedge-Fund Fallout
There is another recent and temporary reason why the Discovery Class C shares look extra cheap.
Bill Hwang — the failed hedge-fund manager whose hedge fund, Archegos Capital, was liquidated recently by its bankers — held a huge stake in Discovery stock. Numerous media sites described this situation, especially The Wall Street Journal and Bloomberg, which had extensive articles on his purchases of Discovery, especially Class A shares.
When the banks liquidated Hwang’s position, the Class A shares got especially decimated. This is important because now those same shares look significantly undervalued, given the company’s huge free cash flow (FCF).
Free Cash Flow at Discovery
Here is the easiest way to handle this situation as a potential investor: determine the FCF yield of the stock in aggregate and then pick the cheapest class share.
For example, as of Apr. 19 Discovery stock had a total market value of $23.13 billion with all classes of its shares outstanding, according to Seeking Alpha.
But last year, the company produced an astounding amount of FCF — $2.337 billion — according to its recent fourth-quarter earnings release. That implies that Discovery’s FCF yield is 10.1% (i.e. $2.337 billion in FCF divided by the $23.13 billion market cap). This is an extremely high FCF yield.
Many other streaming technology companies, like Netflix (NASDAQ:NFLX) and Amazon (NASDAQ:AMZN), have much lower FCF yields, being higher priced. For example, last year Netflix reported that its FCF was $1.9 billion. This represents just 0.78% of its $242 billion market capitalization. Even in 2019, its FCF was $3.3 billion, making for only 1.36% in FCF yield on today’s market cap.
The same goes for Amazon. In 2020, Amazon produced $31 billion in FCF. Using its $1.71 trillion market cap, it has an FCF yield of 1.81%.
Moreover, even ViacomCBS (NASDAQ:VIAC) — which has a similar market cap as Discovery, at $24.32 billion — has a lower FCF yield of 8.1%. This is because it reported $1.97 billion in 2020 FCF.
What Discovery Stock Is Worth
Therefore, if we took an average of all of these peer FCF yields, Discovery should be trading much higher. The average is 3.41%, but to be conservative, let’s just use the ViacomCBS 8.1% FCF. By dividing Discovery’s 2020 FCF of $2.337 billion by 8.1%, we derive a price target of $28.85 billion. That is $5.72 billion higher than its $23.13 billion market cap today. This implies a potential gain of 24.78%.
Moreover, if we use the average of 3.41% FCF yield, assuming that even VIAC stock’s FCF yield is too high, the target market value is $67.82 billion. That is 2.93 times the present price for Discovery stock.
Here is the bottom line: DISCK stock should be trading for at least $38.90 per share (i.e. 24.78% higher than today). Moreover, DISCA should be trading for over $45 per share. So, you can see that Discovery stock — especially Class C shares — are too cheap using this FCF yield analysis.
On the date of publication, Mark R. Hake did not hold (either directly of indirectly) any positions in the securities mentioned in this article.