Are Fawaz Abdulaziz Al Hokair & Company (TADAWUL:4240) Investors Paying Above The Intrinsic Value?

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Fawaz Abdulaziz Al Hokair & Company (TADAWUL:4240) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

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.

See our latest analysis for Fawaz Abdulaziz Al Hokair

Is Fawaz Abdulaziz Al Hokair 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, 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

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (SAR, Millions)	-ر.س60.5m	ر.س248.4m	ر.س311.0m	ر.س376.0m	ر.س387.0m	ر.س404.6m	ر.س428.4m	ر.س457.5m	ر.س491.6m	ر.س530.5m
Growth Rate Estimate Source	Analyst x3	Analyst x4	Analyst x4	Analyst x2	Analyst x1	Est @ 4.55%	Est @ 5.88%	Est @ 6.8%	Est @ 7.45%	Est @ 7.9%
Present Value (SAR, Millions) Discounted @ 19%	-ر.س50.9	ر.س176	ر.س185	ر.س188	ر.س163	ر.س144	ر.س128	ر.س115	ر.س104	ر.س94.4

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ر.س1.2b

The second stage is also known as Terminal Value, this is the business's cash flow after 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 9.0%. We discount the terminal cash flows to today's value at a cost of equity of 19%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = ر.س530m× (1 + 9.0%) ÷ (19%– 9.0%) = ر.س5.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= ر.س5.9b÷ ( 1 + 19%)¹⁰= ر.س1.0b

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.س2.3b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of ر.س13.8, the company appears slightly overvalued 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

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. 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 Fawaz Abdulaziz Al Hokair 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 19%, 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.

Looking Ahead:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. 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. What is the reason for the share price exceeding the intrinsic value? For Fawaz Abdulaziz Al Hokair, we've compiled three pertinent aspects you should assess:

1. Risks: For instance, we've identified 1 warning sign for Fawaz Abdulaziz Al Hokair that you should be aware of.
2. Future Earnings: How does 4240'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. 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.