Stock Analysis

Is Sims Limited (ASX:SGM) Trading At A 30% Discount?

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ASX:SGM
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Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, Sims fair value estimate is AU$22.11
  • Current share price of AU$15.54 suggests Sims is potentially 30% undervalued
  • Our fair value estimate is 55% higher than Sims' analyst price target of AU$14.22

Today we will run through one way of estimating the intrinsic value of Sims Limited (ASX:SGM) by taking the forecast future cash flows of the company and discounting them back to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

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. 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.

See our latest analysis for Sims

The Method

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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, 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) estimate

2024 2025 2026 2027 2028 2029 2030 2031 2032 2033
Levered FCF (A$, Millions) AU$68.0m AU$235.0m AU$252.5m AU$265.8m AU$277.2m AU$287.3m AU$296.4m AU$304.8m AU$312.7m AU$320.4m
Growth Rate Estimate Source Analyst x2 Analyst x2 Analyst x2 Est @ 5.25% Est @ 4.30% Est @ 3.63% Est @ 3.17% Est @ 2.84% Est @ 2.61% Est @ 2.45%
Present Value (A$, Millions) Discounted @ 8.1% AU$62.9 AU$201 AU$200 AU$195 AU$188 AU$180 AU$172 AU$163 AU$155 AU$147

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$1.7b

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 5-year average of the 10-year government bond yield (2.1%) 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%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = AU$320m× (1 + 2.1%) ÷ (8.1%– 2.1%) = AU$5.4b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$5.4b÷ ( 1 + 8.1%)10= AU$2.5b

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$4.2b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of AU$15.5, the company appears a touch undervalued at a 30% 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.

dcf
ASX:SGM Discounted Cash Flow December 22nd 2023

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 8.1%, which is based on a levered beta of 1.205. 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

Strength
  • Debt is well covered by cash flow.
  • Dividends are covered by earnings and cash flows.
Weakness
  • Earnings declined over the past year.
  • Interest payments on debt are not well covered.
  • Dividend is low compared to the top 25% of dividend payers in the Metals and Mining market.
Opportunity
  • Annual earnings are forecast to grow for the next 3 years.
  • Good value based on P/E ratio and estimated fair value.
Threat
  • Annual earnings are forecast to grow slower than the Australian market.

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. DCF models are not the be-all and end-all of investment valuation. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Sims, there are three essential items you should further examine:

  1. Risks: To that end, you should be aware of the 2 warning signs we've spotted with Sims .
  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 High Quality Alternatives: Do you like a good all-rounder? 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.

Valuation is complex, but we're helping make it simple.

Find out whether Sims is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.

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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.