A Look At The Intrinsic Value Of Saudi Electricity Company (TADAWUL:5110)

Key Insights

• Saudi Electricity's estimated fair value is ر.س23.8 based on 2 Stage Free Cash Flow to Equity
• Current share price of ر.س23.4 suggests Saudi Electricity is trading close to its fair value
• Saudi Electricity's peers are currently trading at a premium of 1,887% on average

In this article we are going to estimate the intrinsic value of Saudi Electricity Company (TADAWUL:5110) by projecting its future cash flows and then discounting them to today's value. This will be done using 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.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

View our latest analysis for Saudi Electricity

Is Saudi Electricity 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. 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) forecast

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (SAR, Millions)	ر.س8.63b	ر.س7.95b	ر.س7.72b	ر.س7.78b	ر.س8.02b	ر.س8.41b	ر.س8.92b	ر.س9.53b	ر.س10.2b	ر.س11.1b
Growth Rate Estimate Source	Analyst x1	Est @ -7.88%	Est @ -2.86%	Est @ 0.66%	Est @ 3.12%	Est @ 4.85%	Est @ 6.05%	Est @ 6.90%	Est @ 7.49%	Est @ 7.90%
Present Value (SAR, Millions) Discounted @ 14%	ر.س7.5k	ر.س6.1k	ر.س5.1k	ر.س4.5k	ر.س4.1k	ر.س3.7k	ر.س3.5k	ر.س3.2k	ر.س3.0k	ر.س2.9k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ر.س44b

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 8.9%. We discount the terminal cash flows to today's value at a cost of equity of 14%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = ر.س11b× (1 + 8.9%) ÷ (14%– 8.9%) = ر.س215b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= ر.س215b÷ ( 1 + 14%)¹⁰= ر.س56b

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.س99b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of ر.س23.4, the company appears about fair value at a 1.7% 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

Now 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 Saudi Electricity 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 14%, which is based on a levered beta of 0.800. 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.

SWOT Analysis for Saudi Electricity

Next Steps:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Saudi Electricity, we've put together three fundamental elements you should further research:

1. Risks: You should be aware of the 1 warning sign for Saudi Electricity we've uncovered before considering an investment in the company.
2. Future Earnings: How does 5110'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. 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.