Is United Electronics Company (TADAWUL:4003) Worth ر.س92.8 Based On Its Intrinsic Value?

Today we will run through one way of estimating the intrinsic value of United Electronics Company (TADAWUL:4003) by taking the expected future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

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. 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 United Electronics

Crunching the numbers

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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (SAR, Millions)	ر.س307.0m	ر.س340.0m	ر.س371.4m	ر.س405.3m	ر.س442.0m	ر.س481.7m	ر.س524.9m	ر.س571.7m	ر.س622.7m	ر.س678.1m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ 9.23%	Est @ 9.13%	Est @ 9.05%	Est @ 8.99%	Est @ 8.96%	Est @ 8.93%	Est @ 8.91%	Est @ 8.9%
Present Value (SAR, Millions) Discounted @ 17%	ر.س263	ر.س250	ر.س234	ر.س218	ر.س204	ر.س190	ر.س178	ر.س166	ر.س155	ر.س144

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ر.س2.0b

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)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = ر.س678m× (1 + 8.9%) ÷ (17%– 8.9%) = ر.س9.4b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= ر.س9.4b÷ ( 1 + 17%)¹⁰= ر.س2.0b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is ر.س4.0b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of ر.س92.8, the company appears reasonably expensive at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 United Electronics 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 1.255. 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:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" 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. Can we work out why the company is trading at a premium to intrinsic value? For United Electronics, we've compiled three fundamental factors you should further research:

1. Risks: For instance, we've identified 2 warning signs for United Electronics that you should be aware of.
2. Future Earnings: How does 4003'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. 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. 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.
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