Is There An Opportunity With St Barbara Limited's (ASX:SBM) 34% Undervaluation?

Today we will run through one way of estimating the intrinsic value of St Barbara Limited (ASX:SBM) by taking the forecast future cash flows of the company and discounting them back to today's value. Our analysis will employ 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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

View our latest analysis for St Barbara

Crunching the numbers

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. 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (A$, Millions)	AU$104.3m	AU$202.7m	AU$135.3m	AU$130.9m	AU$128.7m	AU$127.9m	AU$128.1m	AU$128.9m	AU$130.3m	AU$132.0m
Growth Rate Estimate Source	Analyst x3	Analyst x3	Analyst x3	Est @ -3.27%	Est @ -1.71%	Est @ -0.62%	Est @ 0.14%	Est @ 0.67%	Est @ 1.05%	Est @ 1.31%
Present Value (A$, Millions) Discounted @ 7.2%	AU$97.4	AU$176	AU$110	AU$99.2	AU$91.0	AU$84.4	AU$78.9	AU$74.1	AU$69.9	AU$66.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$947m

The second stage is also known as Terminal Value, this is the business's cash flow after 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 1.9%. We discount the terminal cash flows to today's value at a cost of equity of 7.2%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = AU$132m× (1 + 1.9%) ÷ (7.2%– 1.9%) = AU$2.6b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$2.6b÷ ( 1 + 7.2%)¹⁰= AU$1.3b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is AU$2.2b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of AU$2.1, the company appears quite undervalued at a 34% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

The assumptions

Now 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 St Barbara 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 7.2%, which is based on a levered beta of 1.112. 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. 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. What is the reason for the share price sitting below the intrinsic value? For St Barbara, there are three important items you should look at:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with St Barbara , and understanding this should be part of your investment process.
2. Future Earnings: How does SBM'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.

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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. 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.
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