SGS SA's (VTX:SGSN) Intrinsic Value Is Potentially 50% Above Its Share Price

Key Insights

• The projected fair value for SGS is CHF110 based on 2 Stage Free Cash Flow to Equity

• SGS is estimated to be 33% undervalued based on current share price of CHF73.06

• The CHF84.53 analyst price target for SGSN is 23% less than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of SGS SA (VTX:SGSN) by projecting its future cash flows and then discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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. 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 SGS

The Method

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) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CHF, Millions)	CHF758.1m	CHF807.7m	CHF855.3m	CHF921.3m	CHF983.0m	CHF1.02b	CHF1.05b	CHF1.08b	CHF1.09b	CHF1.10b
Growth Rate Estimate Source	Analyst x9	Analyst x9	Analyst x3	Analyst x3	Analyst x2	Est @ 4.19%	Est @ 2.95%	Est @ 2.09%	Est @ 1.49%	Est @ 1.07%
Present Value (CHF, Millions) Discounted @ 5.2%	CHF721	CHF730	CHF735	CHF752	CHF763	CHF755	CHF739	CHF717	CHF692	CHF665

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CHF7.3b

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. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (0.08%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 5.2%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CHF1.1b× (1 + 0.08%) ÷ (5.2%– 0.08%) = CHF22b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CHF22b÷ ( 1 + 5.2%)¹⁰= CHF13b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is CHF20b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of CHF73.1, the company appears quite good value at a 33% 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.

SWX:SGSN Discounted Cash Flow January 19th 2024

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 SGS 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 5.2%, which is based on a levered beta of 1.025. 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 SGS

Strength

• Debt is well covered by earnings and cashflows.

• Dividend is in the top 25% of dividend payers in the market.

Weakness

• Earnings declined over the past year.

Opportunity

• Annual earnings are forecast to grow faster than the Swiss market.

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

Threat

• Dividends are not covered by earnings.

• Revenue is forecast to grow slower than 20% per year.

Next Steps:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching 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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Why is the intrinsic value higher than the current share price? For SGS, we've put together three essential elements you should explore:

1. Risks: We feel that you should assess the 2 warning signs for SGS we've flagged before making an investment in the company.

2. Future Earnings: How does SGSN'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 Swiss 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.