A Look At The Fair Value Of Sims Limited (ASX:SGM)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Sims fair value estimate is AU$15.42
• With AU$13.66 share price, Sims appears to be trading close to its estimated fair value
• Analyst price target for SGM is AU$13.05 which is 15% below our fair value estimate

In this article we are going to estimate the intrinsic value of Sims Limited (ASX:SGM) by taking the expected future cash flows and discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Believe it or not, it's not too difficult to follow, as you'll see from our example!

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.

View our latest analysis for Sims

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$147.6m	AU$182.6m	AU$177.2m	AU$175.2m	AU$175.1m	AU$176.5m	AU$178.8m	AU$181.8m	AU$185.3m	AU$189.3m
Growth Rate Estimate Source	Analyst x3	Analyst x3	Analyst x3	Est @ -1.14%	Est @ -0.03%	Est @ 0.76%	Est @ 1.30%	Est @ 1.69%	Est @ 1.95%	Est @ 2.14%
Present Value (A$, Millions) Discounted @ 7.7%	AU$137	AU$157	AU$142	AU$130	AU$121	AU$113	AU$106	AU$100	AU$94.7	AU$89.8

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$1.2b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 5-year average of the 10-year government bond yield (2.6%) 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 7.7%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = AU$189m× (1 + 2.6%) ÷ (7.7%– 2.6%) = AU$3.8b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$3.8b÷ ( 1 + 7.7%)¹⁰= AU$1.8b

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$3.0b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of AU$13.7, the company appears about fair value at a 11% 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 Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own assumptions. 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 Sims 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 1.253. 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.

SWOT Analysis for Sims

Next Steps:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Sims, we've compiled three important elements you should further research:

1. Risks: Case in point, we've spotted 3 warning signs for Sims you should be aware of.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for SGM's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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.