Engineering conglomerate Singapore Technologies Engineering Ltd (SGX: S63) has not had the best of times over the past 12 months. In that time frame, the company?s shares are down by 14.7% to S$2.89 currently.
With that double-digit decline, it might be worth asking, is Singapore Technologies Engineering a possible bargain now? Let?s find out by thinking of how we can value the company.
To come up with a value for a firm, we can use a Discounted Cash Flow (DCF) model, which essentially sums up all the cash that a company can produce over its lifetime before discounting them back…
Engineering conglomerate Singapore Technologies Engineering Ltd (SGX: S63) has not had the best of times over the past 12 months. In that time frame, the company’s shares are down by 14.7% to S$2.89 currently.
With that double-digit decline, it might be worth asking, is Singapore Technologies Engineering a possible bargain now? Let’s find out by thinking of how we can value the company.
To come up with a value for a firm, we can use a Discounted Cash Flow (DCF) model, which essentially sums up all the 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 is to first predict how fast a company can grow its free cash flows over the next 10 years. This is followed by an estimate of how fast said 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 like the one we just described is a useful tool. But, there are some issues that investors have to note.
In his book Value Investing, 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 model. 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.
So, instead of trying to find the value of Singapore Technologies Engineering by working our grey matter to estimate the growth rates that the company can achieve, let’s do it backwards instead, Montier style.
For the reverse-engineered DCF model, here are some of the raw 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 number, which is central to what we’re doing here, is very important in an investing context. It is the actual cash brought in by a company’s operations that’s left after the firm has spent the necessary money needed to maintain its businesses at their current state (this is known as capital expenditures). A company can then use the free cash flow it has to benefit shareholders in a number of ways, such as paying dividends, buying back stock, strengthening the balance sheet, and investing for growth.
Over the last 12 months, Singapore Technologies Engineering has generated S$323 million in free cash flow (S$536 million in operating cash flow minus S$212 million in capital expenditures) and has a weighted average share count of 3.11 billion, according to S&P Capital IQ. This brings the engineering conglomerate’s free cash flow per share to S$0.104.
For the discount rate, I’d keep things simple and use a hurdle rate (essentially the rate of return an investor will require) of 15%. It’s worth noting though that the more academically-accepted version of the discount rate involves deeper number-crunching as it takes into account the current rate of return on a risk-free investment and the historical volatility of the stock.
Regarding the terminal growth rate, the long-run inflation rate in Singapore, which is between 2% and 3%, can be a good proxy. I’d be going with 3% here.
So, here’s what we have so far:
- Current share price: S$2.89
- Free cash flow per share over the last 12 months: S$0.104
- A discount rate: 15%
- A terminal growth rate for the company’s cash flows: 3%
With all the bits above, we can then noodle around with the growth rates for Singapore Technologies Engineering’s free cash flows for the first 10 years. Based on my own calculations, the market expects the engineering conglomerate, at its current stock price, to grow its free cash flows at 27% per year for the first five-year block, and 13.5% annually for the next five.
A Fool’s take
You might already have noticed that even a reverse-engineered DCF model is fraught with its own set of difficulties: Investors have to come up with their own discount rates as well as a terminal growth rate.
But, a reverse-engineered DCF model is still very helpful as it makes us think with every stock, “What’s priced in?”
Coming back to Singapore Technologies Engineering, does its implied growth rates look reasonable? This is where our own personal judgements will have to come into play. 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.