2015 hasn’t been the best of years so far for Singapore’s market barometer, the Straits Times Index (SGX: ^STI). Since the start of the year, it has declined by 16%. In these poor market conditions, stock exchange operator Singapore Exchange Limited (SGX: S68) has been a bastion. At its current price of S$7.58, it’s down by a mere 2.9% since the beginning of 2015. Is the resilience of Singapore Exchange’s stock a sign of value in the company? Let’s find out by thinking of how we can possibly value the firm. In search of value To estimate the value, or…
2015 hasn’t been the best of years so far for Singapore’s market barometer, the Straits Times Index (SGX: ^STI). Since the start of the year, it has declined by 16%.
In these poor market conditions, stock exchange operator Singapore Exchange Limited (SGX: S68) has been a bastion. At its current price of S$7.58, it’s down by a mere 2.9% since the beginning of 2015.
Is the resilience of Singapore Exchange’s stock a sign of value in the company? Let’s find out by thinking of how we can possibly value the firm.
In search of value
To estimate the value, or economic worth, of 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 gauge that amount of cash is to first predict how fast a company can grow its free cash flows (more on the free cash flow later) 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 forward-looking 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 prevent these issues from running amok, Montier had suggested investors use a reverse-engineered DCF model. Instead of having to pull all kinds of fuzzy figures from the ether 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.
Pinpointing that value
So, instead of trying to find the value of Singapore Exchange by thinking about what growth rates we should use for a traditional DCF model, 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/or investing for growth.
Over the last 12 months, Singapore Exchange has generated S$362 million in free cash flow (S$442 million in operating cash flow minus S$80 million in capital expenditures) and has a weighted average share count of 1.07 billion, according to S&P Capital IQ. This brings the stock market outfit’s free cash flow per share to S$0.338.
For the discount rate, I’d keep things simple and use a hurdle rate (essentially the rate of return an investor will require of an investment) of 15%. It’s worth noting though that the more academically-accepted version of the discount rate involves deeper calculations 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 all that we have so far:
- Current share price: S$7.58
- Free cash flow per share over the last 12 months: S$0.338
- A discount rate: 15%
- A terminal growth rate for the company’s cash flows: 3%
Using the numbers, we can then play around with the growth rates for Singapore Exchange’s free cash flows for the first 10 years. Based on my own number crunching, the market expects the bourse operator, at its current stock price, to grow its free cash flows at 22.65% per year for the first five-year block, followed by 13.5% annually for the next five.
A Fool’s take
Some of you might already have noticed that even a reverse-engineered DCF model comes with its own set of difficulties and that is, 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 of the following question with every stock: “What’s priced in?” Being able to answer that is useful as it juxtaposes the market’s expectations with your own assessment of the company’s growth potential.
Coming back to Singapore Exchange, 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.