Saudi Ceramic Company's (TADAWUL:2040) Intrinsic Value Is Potentially 80% Above Its Share Price

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Saudi Ceramic Company (TADAWUL:2040) as an investment opportunity 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. It may sound complicated, but actually it is quite simple!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for Saudi Ceramic

Crunching The Numbers

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.

Generally we assume that a dollar today is more valuable than a dollar in the future, 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

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (SAR, Millions)	ر.س170.0m	ر.س254.0m	ر.س325.4m	ر.س398.2m	ر.س471.1m	ر.س544.0m	ر.س617.5m	ر.س692.3m	ر.س769.4m	ر.س850.0m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ 28.13%	Est @ 22.35%	Est @ 18.31%	Est @ 15.48%	Est @ 13.5%	Est @ 12.11%	Est @ 11.14%	Est @ 10.47%
Present Value (SAR, Millions) Discounted @ 15%	ر.س148	ر.س193	ر.س215	ر.س230	ر.س237	ر.س238	ر.س236	ر.س230	ر.س223	ر.س215

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ر.س2.2b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 8.9%. We discount the terminal cash flows to today's value at a cost of equity of 15%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = ر.س850m× (1 + 8.9%) ÷ (15%– 8.9%) = ر.س16b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= ر.س16b÷ ( 1 + 15%)¹⁰= ر.س4.0b

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 ر.س6.2b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of ر.س42.9, the company appears quite good value at a 44% 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

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Saudi Ceramic 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 15%, which is based on a levered beta of 1.186. 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:

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 Saudi Ceramic, there are three pertinent elements you should assess:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Saudi Ceramic , and understanding this should be part of your investment process.
2. Future Earnings: How does 2040'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 SASE 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. 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.