Is There An Opportunity With Arabian Centres Company's (TADAWUL:4321) 40% Undervaluation?

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Arabian Centres Company (TADAWUL:4321) as an investment opportunity 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. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

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 Arabian Centres

Is Arabian Centres Fairly Valued?

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. 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

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (SAR, Millions)	ر.س809.8m	ر.س1.03b	ر.س1.54b	ر.س1.70b	ر.س1.87b	ر.س2.05b	ر.س2.25b	ر.س2.46b	ر.س2.68b	ر.س2.92b
Growth Rate Estimate Source	Analyst x3	Analyst x3	Analyst x2	Est @ 10.55%	Est @ 10.05%	Est @ 9.7%	Est @ 9.45%	Est @ 9.28%	Est @ 9.16%	Est @ 9.08%
Present Value (SAR, Millions) Discounted @ 17%	ر.س692	ر.س751	ر.س959	ر.س905	ر.س851	ر.س797	ر.س746	ر.س696	ر.س649	ر.س605

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ر.س7.7b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 8.9%. We discount the terminal cash flows to today's value at a cost of equity of 17%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = ر.س2.9b× (1 + 8.9%) ÷ (17%– 8.9%) = ر.س39b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= ر.س39b÷ ( 1 + 17%)¹⁰= ر.س8.0b

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.س16b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of ر.س19.9, the company appears quite undervalued at a 40% 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.

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Arabian Centres 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 1.658. 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.

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and 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. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Arabian Centres, we've compiled three further items you should consider:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Arabian Centres (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.
2. Future Earnings: How does 4321'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 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. Simply Wall St updates its DCF calculation for every Saudi stock every day, so if you want to find the intrinsic value of any other stock 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.