Once you’ve a trading account with a brokerage firm, it’s likely that your broker would start sending you brokerage reports covering any of the companies you might be interested in. In most of such reports, there tends to be a section on valuation, showing you what the company in question should be worth and how much “upside” or “downside” you can expect if you decide to invest at any point in time. But it’s good to point out that such valuation figures shouldn’t be taken to be gospel for what a certain share is worth. To add more meat…
In most of such reports, there tends to be a section on valuation, showing you what the company in question should be worth and how much “upside” or “downside” you can expect if you decide to invest at any point in time.
But it’s good to point out that such valuation figures shouldn’t be taken to be gospel for what a certain share is worth. To add more meat to my statement, I would like to do a little experiment today. Hopefully, it can show you the dangers behind valuation techniques and why you should not follow anyone’s valuation model blindly.
How much is SingTel worth?
For my experiment, let us try to value Singapore Telecommunications Limited (SGX: Z74), the largest company in Singapore by market capitalisation and thus a company which would likely be familiar with many investors.
As there are many methods of valuing a company, (some methods include using metrics such as a company’s price to earnings (P/E) or price to book (P/B) ratios while some would require the use of discounted cash flow models), I will simplify the exercise by using a simple one step discounted cash flow model.
Please note that this is not an actual valuation of SingTel. Rather, it is an illustration of how the value of a company can be easily adjusted based on different assumptions.
The formula for a Steady Growth Discounted Free Cash Flow valuation is this:
Equity Value of Company = Expected Free Cash Flow / (Cost of Equity – Growth Rate)
All three inputs of the formula require significant assumptions to be made. For example, the free cash flow of SingTel has fluctuated wildly over the past decade; from 2004 till today, the annual free cash flow generated by the company has ranged from S$280 million to S$3.9 billion. Therefore, to even put a number on the expected free cash flow requires a lot of assumptions on the person performing the valuation.
To illustrate how important the assumptions can be in determining the value of a company, let’s start with a set of conservative assumptions. Let’s say that the expected free cash flow for SingTel in the next year is S$1.0 billion. Its cost of equity should be at least 10% since there are shares in the market giving yields near that level. Lastly, I might assume SingTel to exhibit growth of only 1% a year since it is already the market leader in many of the countries it operates in.
If I input all these figures into the formula, I would only end up valuing SingTel at about S$0.70 per share. That’s a far cry from its current price of S$3.95. Yet, I have not made any bizarre assumptions on any of the inputs.
So tell me, how much do you want Singtel to be worth?
If you’ve not realised yet, the act of valuing a company is a very subjective process. Any investor can basically value SingTel at any figure with a simple change in assumptions.
To prove the point, let me be more bullish on Singtel. I can assume the following: the company has an expected free cash flow of S$4.0 billion; it has a cost of equity of 6% (since it is a blue chip company it is less risky); and it can grow at around 5% a year. If I do that, the model would spit out a value of S$25 per share for SingTel. That’s six times more than its current price.
Depending on my assumptions, I can peg SingTel to be worth anywhere between S$0.70 and S$25 per share. I hope I have illustrated the dangers inherent in a valuation model.
The next time you read a report or hear someone explaining to you how much a company should be worth, remember to always ask what the assumptions are and decide for yourself if you agree with what’s being assumed.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Stanley Lim doesn’t own shares in any companies mentioned.