SATS Ltd (SGX: S58) is a relative newcomer in Singapore’s market benchmark, the Straits Times Index (SGX: ^STI), having joined in just September this year. As a provider of catering services to airlines and ground handling services at airports, SATS is a company that could potentially ride on the growth of the air travel industry. And, growth there might just be. According to aircraft manufacturer Airbus’ recent Global Market Forecast 2015-2034 report, global air traffic is forecasted to climb at an annual rate of 4.6% over the next 20 years. That rate of growth represents more than a…
As a provider of catering services to airlines and ground handling services at airports, SATS is a company that could potentially ride on the growth of the air travel industry.
And, growth there might just be. According to aircraft manufacturer Airbus’ recent Global Market Forecast 2015-2034 report, global air traffic is forecasted to climb at an annual rate of 4.6% over the next 20 years. That rate of growth represents more than a doubling of air traffic flow by 2034.
While there seems to be lovely tailwinds for SATS’ business, it does not necessarily mean that the company’s shares will be a good investment. The price paid will have to make sense too.
How then can we ‘make this sense?’ Glad you asked. A good – but certainly imperfect – way to do so would be to use a reverse-engineered discounted cash flow (DCF) model to determine what growth rates are implied by the market at SATS’s current stock price of S$3.82.
A DCF model, in essence, sums up all the estimated cash that a company can produce over its lifetime before discounting that sum to the present.
The popular way to estimate that amount of cash is to first predict how fast a company can grow its free cash flows over the next 10 years. After which, we’d then think of how fast the company can bump up its annual free cash flows from the 11th year onward to perpetuity. The latter growth number is known as the terminal growth rate.
Now, a forward-looking DCF that I’ve just described is a useful tool. But, there are some issues with the technique. James Montier, a member of the asset-allocation at the highly successful investing firm GMO, has pointed out a few. In his book Value Investing, Montier wrote that forward-looking DCFs have “problems with estimating cash flows, and problems with estimating the discount rate.”
A reverse-engineered DCF helps alleviate some of those issues. Instead of estimating a company’s growth rates to be punched into the model, a reverse-engineered DCF looks at the stock’s current price and works out how much growth the market expects.
We can then use our own judgement to see if the implied growth rates make any sense or not.
To work a reverse-engineered DCF, here are some of the ingredients we need:
- 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 number we need for SATS.
The free cash flow figure is something important for investors to note. It is the actual leftover cash brought in by a company’s operations after the necessary capital has been spent to maintain the firm’s businesses at their current state. A company can then use its free cash flows to benefit shareholders in a number of ways, including paying dividends, buying back stock, investing in growth opportunities, or strengthening the balance sheet.
Over the last 12 months, SATS had generated S$174.3 million in free cash flow and has a weighted average share count of 1.110 billion, according to S&P Capital IQ. This gives the airline caterer S$0.157 in free cash flow per share.
For the discount rate, I’d stick to something simple and use my own required rate of return of 15%. This is also known as a ‘hurdle’ rate. I should point out though, that the more academically-accepted version of the discount rate will take into account the current rate of return for a risk-free investment as well as the historical volatility of the stock in question.
Coming to the terminal growth rate, we can use the long-run rate of inflation in Singapore, which clocks in at between 2% and 3%, as a good proxy. I’d go with 3% here.
If we put together all that we know so far, this is what we have:
- Current share price: S$3.82
- Free cash flow per share over the last 12 months: S$0.157
- A discount rate: 15%
- A terminal growth rate for the company’s cash flows: 3%
Using these figures, we can then play around with the growth rates for free cash flow in the first 10 years. Based on my calculations, the market expects SATS to be growing its free cash flow at an annual rate of 24.3% over the first five year block, followed by 12.1% annually over the next five.
A Fool’s take
Sharp Fools reading this might notice that even a 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 growth rate. That’s why I had said the model is an imperfect one earlier.
But nonetheless, with a reverse-engineered DCF model, investors will constantly have to ask themselves, “What’s priced in?” That is a very helpful thought to have.
Coming back to SATS, does its implied growth rates look reasonable? This is where you’d have to exercise some independent thinking. Let me know what you think in the comments section below!
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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 writer Chong Ser Jing doesn't own shares in any company mentioned.