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 taking the expected future cash flows and discounting them to today' s value. One way to achieve this is by employing 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.

See our latest analysis for Sembcorp Industries

Step by step through the calculation

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.

Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today' s value:

10-year free cash flow (FCF) estimate

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (SGD, Millions)	S$433.4m	S$389.0m	S$364.0m	S$349.6m	S$341.9m	S$338.4m	S$337.8m	S$339.2m	S$342.0m	S$345.9m
Growth Rate Estimate Source	Analyst x3	Analyst x3	Est @ -6.42%	Est @ -3.95%	Est @ -2.23%	Est @ -1.02%	Est @ -0.17%	Est @ 0.42%	Est @ 0.83%	Est @ 1.12%
Present Value (SGD, Millions) Discounted @ 5.7%	S$410	S$348	S$308	S$280	S$259	S$242	S$229	S$217	S$207	S$198

(" Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF)  = S$2.7b

The second stage is also known as Terminal Value, this is the business' s cash flow after 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 (1.8%) 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 5.7%.

Terminal Value (TV)= FCF₂₀₃₁  × (1 + g) ÷ (r &ndash g) = S$346m× (1 + 1.8%) ÷ (5.7%&ndash 1.8%) = S$8.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= S$8.9b÷ ( 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$7.8b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of S$2.6, the company appears quite undervalued at a 41% 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. SGX:U96 Discounted Cash Flow February 18th 2022

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 0.930. 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.

Next Steps:

Whilst important, the DCF calculation ideally won' t be the sole piece of analysis you scrutinize 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?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For Sembcorp Industries, we' ve put together three essential items you should further research:

1. Risks: We feel that you should assess the  3 warning signs for Sembcorp Industries  (1 is a bit unpleasant!) we' ve flagged before making an investment in the company.
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!