Are SGH Limited (ASX:SGH) Investors Paying Above The Intrinsic Value?

Key Insights

• SGH's estimated fair value is AU$41.29 based on 2 Stage Free Cash Flow to Equity
• SGH is estimated to be 24% overvalued based on current share price of AU$51.29
• Analyst price target for SGH is AU$53.28, which is 29% above our fair value estimate

How far off is SGH Limited (ASX:SGH) 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 today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Our free stock report includes 1 warning sign investors should be aware of before investing in SGH. Read for free now.

The Method

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (A$, Millions)	AU$498.4m	AU$797.6m	AU$919.2m	AU$832.0m	AU$944.0m	AU$978.4m	AU$1.01b	AU$1.04b	AU$1.08b	AU$1.11b
Growth Rate Estimate Source	Analyst x4	Analyst x4	Analyst x3	Analyst x1	Analyst x1	Est @ 3.64%	Est @ 3.37%	Est @ 3.18%	Est @ 3.05%	Est @ 2.96%
Present Value (A$, Millions) Discounted @ 7.7%	AU$463	AU$687	AU$735	AU$617	AU$650	AU$625	AU$600	AU$574	AU$549	AU$525

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$6.0b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.7%. We discount the terminal cash flows to today's value at a cost of equity of 7.7%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = AU$1.1b× (1 + 2.7%) ÷ (7.7%– 2.7%) = AU$23b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$23b÷ ( 1 + 7.7%)¹⁰= AU$11b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$17b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of AU$51.3, the company appears slightly overvalued at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

The Assumptions

We would point out that 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 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 SGH 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 7.7%, which is based on a levered beta of 1.156. 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.

See our latest analysis for SGH

SWOT Analysis for SGH

Next Steps:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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. Can we work out why the company is trading at a premium to intrinsic value? For SGH, we've put together three further factors you should further examine:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with SGH , and understanding it should be part of your investment process.
2. Future Earnings: How does SGH'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 Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.