Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Simonds Group Limited (ASX:SIO) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. This is done using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To start off with, we need to estimate the next ten years of cash flows. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
Generally we assume that a dollar today is more valuable than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) forecast
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
Levered FCF (A$, Millions)
A$3.7m
A$3.4m
A$3.3m
A$3.2m
A$3.1m
A$3.1m
A$3.1m
A$3.2m
A$3.2m
A$3.3m
Growth Rate Estimate Source
Est @ -12.64%
Est @ -8.15%
Est @ -5.01%
Est @ -2.82%
Est @ -1.28%
Est @ -0.2%
Est @ 0.55%
Est @ 1.08%
Est @ 1.45%
Est @ 1.71%
Present Value (A$, Millions) Discounted @ 8.13%
A$3.5
A$2.9
A$2.6
A$2.3
A$2.1
A$2.0
A$1.8
A$1.7
A$1.6
A$1.5
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF)= A$21.9m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 10-year government bond rate (2.3%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 8.1%.
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = A$AU$57m ÷ ( 1 + 8.1%)10 = A$26.30m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is A$48.24m. The last step is to then divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate of A$0.34. Relative to the current share price of A$0.40, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
ASX:SIO Intrinsic value, August 1st 2019
The assumptions
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at Simonds Group as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we've used 8.1%, which is based on a levered beta of 0.977. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally 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. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For Simonds Group, I've put together three additional aspects you should further research:
Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of SIO? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the ASX every day. If you want to find the calculation for other stocks just search here.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.
