A Look At The Fair Value Of Sembcorp Industries Ltd (SGX:U96)

Key Insights

• Sembcorp Industries' estimated fair value is S$5.07 based on 2 Stage Free Cash Flow to Equity

• Current share price of S$5.81 suggests Sembcorp Industries is potentially trading close to its fair value

• Our fair value estimate is 25% lower than Sembcorp Industries' analyst price target of S$6.78

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Sembcorp Industries Ltd (SGX:U96) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

View our latest analysis for Sembcorp Industries

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. 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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (SGD, Millions)	S$2.00b	S$342.8m	S$324.3m	S$314.0m	S$309.0m	S$307.5m	S$308.3m	S$310.7m	S$314.4m	S$318.9m
Growth Rate Estimate Source	Analyst x1	Analyst x2	Est @ -5.40%	Est @ -3.16%	Est @ -1.60%	Est @ -0.50%	Est @ 0.26%	Est @ 0.80%	Est @ 1.17%	Est @ 1.44%
Present Value (SGD, Millions) Discounted @ 5.7%	S$1.9k	S$307	S$274	S$251	S$234	S$220	S$209	S$199	S$190	S$183

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = S$4.0b

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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 5.7%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = S$319m× (1 + 2.1%) ÷ (5.7%– 2.1%) = S$8.8b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= S$8.8b÷ ( 1 + 5.7%)¹⁰= S$5.1b

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 S$9.0b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of S$5.8, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf

Important 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 Sembcorp Industries 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 5.7%, 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 Sembcorp Industries

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is well covered by earnings and cashflows.

• Dividends are covered by earnings and cash flows.

Weakness

• Dividend is low compared to the top 25% of dividend payers in the Integrated Utilities market.

• Expensive based on P/E ratio and estimated fair value.

Opportunity

• U96's financial characteristics indicate limited near-term opportunities for shareholders.

Threat

• Annual earnings are forecast to decline for the next 2 years.

Next Steps:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. 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. 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. For Sembcorp Industries, we've compiled three relevant aspects you should further examine:

1. Risks: To that end, you should learn about the 2 warning signs we've spotted with Sembcorp Industries (including 1 which is a bit unpleasant) .

2. Future Earnings: How does U96'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 SGX every day. If you want to find the calculation for other stocks just search here.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.