How far off is Chip Eng Seng Corporation Ltd (SGX:C29) from its intrinsic value? Using the most recent financial data, we’ll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to their present value. I will use the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
Crunching the numbers
We’re using the 2-stage growth model, which simply means we take in account two stages of company’s growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. 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, and so the sum of these future cash flows is then discounted to today’s value:
10-year free cash flow (FCF) estimate
|Levered FCF (SGD, Millions)||S$68.1m||S$70.2m||S$72.1m||S$74.1m||S$75.9m||S$77.8m||S$79.7m||S$81.6m||S$83.5m||S$85.5m|
|Growth Rate Estimate Source||Est @ 3.32%||Est @ 3.01%||Est @ 2.8%||Est @ 2.65%||Est @ 2.55%||Est @ 2.47%||Est @ 2.42%||Est @ 2.39%||Est @ 2.36%||Est @ 2.34%|
|Present Value (SGD, Millions) Discounted @ 14%||S$59.6||S$53.8||S$48.4||S$43.5||S$39.1||S$35.0||S$31.4||S$28.2||S$25.2||S$22.6|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = S$386m
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 14%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = S$85m× (1 + 2.3%) ÷ 14%– 2.3%) = S$734m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= S$734m÷ ( 1 + 14%)10= S$194m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is S$580m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of S$0.6, the company appears about fair value at a 14% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope – move a few degrees and end up in a different galaxy. Do keep this in mind.
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 Chip Eng Seng 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 14%, which is based on a levered beta of 2.000. 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.
Although the valuation of a company is important, 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 Chip Eng Seng, I’ve compiled three essential aspects you should look at:
- Financial Health: Does C29 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.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of C29? 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 updates its DCF calculation for every SG stock every day, so if you want to find the intrinsic value of any other stock just search here.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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