Recently, I shared the market?s expectations of future growth for the three local telecommunications operators in Singapore, namely SingTel (SGX: Z74), Starhub (SGX: CC3) and M1 (SGX: B2F).
I subjected the three companies to a reverse-engineered discounted cash flow (DCF) model using a discount rate of 15%. At their current prices, the model showed that the market was expecting the three telcos ? SingTel, Starhub, and M1 ? to grow their free cash flows for the next 10 years at an annual rate of around 12.8%, 19.5% and 15.5% respectively.
But after thinking about it for a few days, I…
I subjected the three companies to a reverse-engineered discounted cash flow (DCF) model using a discount rate of 15%. At their current prices, the model showed that the market was expecting the three telcos – SingTel, Starhub, and M1 – to grow their free cash flows for the next 10 years at an annual rate of around 12.8%, 19.5% and 15.5% respectively.
But after thinking about it for a few days, I thought of lowering my discount rates. You see, the discount rate I had used was in fact, my hurdle rate. The hurdle rate can be thought of as the rate of return that I want out of my investments.
Let’s frame it in a different way, using SingTel as an example: At a price of S$3.71 per share, the market’s “telling” me that the telco giant’s free cash flow per share has to grow at a compounded annual rate of 12.8% for the next 10 years in order for me to achieve a 15% return per year.
But, there’s another, perhaps more ‘professionally’ and academically-accepted, definition of the discount rate as such:
|Discount Rate = Risk Free Rate of Return + (Equity Risk Premium x Beta of individual share)|
The risk free rate of return is generally taken to be the interest rate received from U.S. 10-year treasury bonds because America is deemed to have the strongest credit in the world (I know that’s up for debate by many, but it’s not something that’s really pertinent to the discussion here).
But in our local context, the interest rate on the Singapore government’s 10-year bonds would suffice as well. And, according to the latest data from the Monetary Authority of Singapore, 10 year government bonds here yield 2.34%.
Moving on, we have the Equity Risk Premium. It can be thought of as the additional return that investors demand on equities, a riskier asset class, compared to the return they could have gotten on risk-free assets.
Professor Aswath Damodaran from the New York University Stern School of Business keeps a really handy table of data, updated annually, on the equity risk premiums for many nations around the world.
The equity risk premium for Singapore’s stock market in general, as of Jan 2013, stands at 5.8%. I know it’s a little outdated, but we can make do with it. And besides, the equity risk premium is supposed to be a figure that’s based on long-run averages of stock market returns, so a difference in timing of less than a year really wouldn’t matter much.
Now, for the last component of the more complicated version of the discount rate, the beta of each individual share. Think of it as a measure of how volatile a share’s price-movement is, historically, relative to a market index.
In Singapore’s case, we’ll be basing the relative-volatility of the three telcos against the Straits Times Index (SGX: ^STI), the most widely quoted market barometer here.
So, let’s now put together all the data that we know regarding the discount rate for the three telcos into the table shown below:
|Company||Risk-free Rate||Equity Risk Premium||Beta*||Discount Rate|
|*5-year beta from S&P Capital IQ|
Using the discount rate figures from above, I played around with my reverse-DCF spreadsheet and came out with the implied-growth figures in free cash flow for the three shares
|Company||Current Share Price||Discount Rate||Implied Annual Free Cash Flow Growth for the next 10 years|
What I’ve come up with seems to suggest that, using the theoretically more complete version of the discount rate, the three telcos are really cheap as the market’s implying that their free cash flows would be shrinking by at least 12.6% per year over the next 10 years.
Is there some revolutionary technology lurking out there that can negate the need for mobile phone carriers, such that services from the likes of SingTel, Starhub, and M1 would become near-obsolete within the next 10 years? I do not have a crystal ball but that idea seems far-fetched at the very least.
So if free cash flows for the telcos would likely not shrink, it seems to suggest that the market has wildly under-priced their shares.
Great! So does that mean we should rush out to buy them now?
Not so fast, buddy. Here’s the rub: the low discount rate we’ve used here consists of moving parts, and they can change.
For example, the risk-free rate is at 2.34% now. But it was just five years ago around mid-2008 when the risk-free rate flirted with the 4% figure. Should the general interest rate environment rise – which is a distinct possibility, especially if the US Federal Reserve starts tapering its quantitative easing programme – the risk-free rate might increase, and thus jack up the discount rate.
When that happens, what looks really attractive now will likely lose its lustre.
In addition, the beta of each share can also change depending on how volatile they are in the future, and that’s something that really cannot be foreseen ahead of time.
Ultimately, the point I’m trying to make here is not that the three telcos are cheap – in fact, my models might well turn out to be dead wrong. The point is that when trying to value shares, it is very easy to come up with scenarios that suggest that certain shares are priced very cheaply. But, are the assumptions that are built into the models robust? Do they conform to reality? Do they appeal to common-sense?
“Are those shares really cheap or do they just seem cheap based on lousy assumptions?” That’s a really good question we need to ask ourselves each time anyone says certain shares are cheap.
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