Stock Analysis

# Calculating The Intrinsic Value Of S P Setia Berhad (KLSE:SPSETIA)

Today we will run through one way of estimating the intrinsic value of S P Setia Berhad (KLSE:SPSETIA) by estimating the company's future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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.

## The Method

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. 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.

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

 2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 Levered FCF (MYR, Millions) RM473.5m RM390.9m RM386.4m RM387.4m RM392.2m RM399.8m RM409.5m RM420.8m RM433.4m RM447.1m Growth Rate Estimate Source Analyst x2 Analyst x2 Est @ -1.15% Est @ 0.26% Est @ 1.25% Est @ 1.94% Est @ 2.42% Est @ 2.76% Est @ 3% Est @ 3.16% Present Value (MYR, Millions) Discounted @ 17% RM406 RM287 RM243 RM209 RM181 RM159 RM139 RM123 RM108 RM95.7

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = RM2.0b

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 (3.6%) 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 17%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = RM447m× (1 + 3.6%) ÷ (17%– 3.6%) = RM3.5b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= RM3.5b÷ ( 1 + 17%)10= RM755m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is RM2.7b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of RM0.6, the company appears about fair value at a 16% 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.

## Important 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 S P Setia Berhad 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 17%, 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 ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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. For S P Setia Berhad, there are three relevant aspects you should further research:

1. Risks: We feel that you should assess the 2 warning signs for S P Setia Berhad (1 is a bit unpleasant!) we've flagged before making an investment in the company.
2. Future Earnings: How does SPSETIA'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 KLSE every day. If you want to find the calculation for other stocks just search here.

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