Land transport giant Comfortdelgro Corporation Ltd (SGX: C52) is currently trading at a stock price of S$3.08. Is that a bargain, a disaster waiting to happen, or something in between? The best way to arrive at an answer would be to estimate the real value of Comfortdelgro stock and that can be done using a Discounted Cash Flow (DCF) model. Finding value In essence, a DCF model sums up all the estimated cash that a company can produce over its lifetime before discounting them back to the present. The popular way to estimate that amount of cash would be to…
Land transport giant Comfortdelgro Corporation Ltd (SGX: C52) is currently trading at a stock price of S$3.08. Is that a bargain, a disaster waiting to happen, or something in between?
The best way to arrive at an answer would be to estimate the real value of Comfortdelgro stock and that can be done using a Discounted Cash Flow (DCF) model.
In essence, a DCF model sums up all the estimated cash that a company can produce over its lifetime before discounting them back to the present.
The popular way to estimate that amount of cash would be to first predict how fast a company can grow its free cash flows over the next 10 years. This is followed by thinking how fast the company can grow its free cash flows from the 11th year onward to perpetuity; this is known as the terminal growth rate.
A DCF model is a useful tool for an investor to have. But, there are issues investors have to note with it.
In his book Value Investing: Tools and Techniques for Intelligent Investment, James Montier, a member of the asset allocation team at the highly successful investing firm GMO, wrote that DCFs have “problems with estimating cash flows, and problems with estimating the discount rate.”
To counter some of these issues, Montier had suggested investors use a reverse-engineered DCF. Instead of estimating all kinds of fuzzy figures as mentioned above, we can look at the current price of a share and use a reverse-engineered valuation model to determine what growth rates are implied by the market at that price.
Comfort in numbers
Montier’s not the only one who thinks it’s useful to work backwards when thinking about the value of a stock. Michael Mauboussin, an investing strategist at Credit Suisse and a very well-respected investment thinker, shares similar thoughts.
To the point, Mauboussin said the following in an interview a couple of years ago:
“Steven Crist, the well-known handicapper, has a line about horse race bettors in his eassay, “Crist on Value”, that I love to repeat. He says, “The issue is not which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory. This may sound elementary, and many players may think they are following this principle, but few actually do.”
Take out the word “horse” and insert the word “stock” and you’ve captured the essence of the problem.”
So, instead of estimating the value of Comfortdelgro’s stock by punching in estimated growth rates into a DCF model, let’s work backwards instead by trying to see what kind of growth the market’s expecting from the company.
To produce a reverse-engineered DCF, here are some of the ingredients we’d require:
- Current share price
- Free cash flow per share over the last 12 months
- A discount rate
- A terminal growth rate for the company’s cash flows
We already have the first figure we need.
The free cash flow figure is important in an investing context; it is essentially the actual cash brought in by a company’s operations after the firm has spent the necessary capital needed to maintain its businesses at their current state. A company can use its free cash flow to benefit shareholders in a number of ways such as paying dividends, buying back stock, strengthening the balance sheet, or investing in growth opportunities.
Comfortdelgro had generated S$126 million in free cash flow over the last 12 months and has 2.14 billion outstanding shares currently, according to S&P Capital IQ. The firm’s free cash flow per share thus stands at S$0.0588.
For the discount rate, I’d be using my own required rate of return, which I’d set at 15% here. The more academically-accepted definition of a discount rate though will take into account the current rate of return for a risk-free investment as well as a stock’s historical volatility in relation to the broader stock market.
Coming to the terminal growth rate, we can simply set it at the historical rate of long-term inflation, which is around 2% to 3% for Singapore. I’d be using 3% here.
So, let’s put together what we have so far:
- Current share price: S$3.08
- Free cash flow per share over the last 12 months: S$0.0588
- A discount rate: 15%
- A terminal growth rate for the company’s cash flows: 3%
Using all the figures that we already know, we can then noodle around with the growth rates for free cash flow in the first 10 years. Based on my calculations, at Comfortdelgro’s current share price, the market is implying that the company would grow its free cash flow at 39.75% per year over the first five years, and then 19.88% annually for the next five.
A Fool’s take
Of course, as sharp readers might notice, even the reverse-engineered DCF is fraught with its own set of difficulties: Investors have to come up with their own discount rates and estimate a share’s terminal free cash flow growth figure.
But nonetheless, with the reverse-engineered DCF, investors will constantly have to ask themselves, “What’s priced in?” That is very helpful in itself.
Coming back to Comfortdelgro, does its implied growth rates make any sense to you as an investor? This is where your own personal judgement comes into play. Let me know what you think in the comments section below!
For more insights on investing and important updates about the stock market, sign up for The Motley Fool Singapore's free weekly investing newsletter, Take Stock Singapore. Written by David Kuo, it can help you grow your wealth in the years ahead.
Like us on Facebook to follow our latest hot articles. The Motley Fool's purpose is to help the world invest, better.
The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn't own shares in any company mentioned.