Is StarHub Ltd A Bargain Blue Chip Stock Now?

Singapore’s second-largest telecommunications company StarHub Ltd (SGX: CC3) is also one of the most important companies in Singapore’s stock market.

The firm is considered a blue chip stock by virtue of its multi-billion market capitalisation (S$6.2 billion, to be exact) and status as one of the 30 constituents in Singapore’s stock market barometer, the Straits Times Index (SGX: ^STI).

Over the past year, StarHub’s share price has fallen by more than 10% to S$3.59 currently. Should investors be buying StarHub’s shares now? Well, it depends.

Yes or no?

The stock market works in a simple manner: The odds of success are in your favour if you buy stocks when they’re cheap and hold them for the long-term.

But, how do we determine if StarHub is a cheap bargain or an over-priced potential money-loser? One way to help answer the question is to look at StarHub’s current price and find out what growth rates in its underlying business fundamentals are implied by the market at that price.

And to do so, we can utilise a reverse-engineered discounted cash flow (DCF) model.

Seeking value

A traditional DCF model, in essence, estimates all the cash that a company can produce over its lifetime, sum them all up, and then discount them back to the present.

The popular way for investors to determine that amount of cash is to predict how fast a company can grow its free cash flow over the next 10 years. This is followed by an estimate of how fast the company can grow its free cash flows from the 11th year onward to perpetuity, otherwise known as the terminal growth rate.

In this sense, you can see how a traditional DCF model works forward. A reverse-engineered DCF model, as its name suggests and as already alluded to, works backwards. We’ll be using StarHub’s current price here to determine the implied growth rates in the firm’s free cash flows.

Calculating value

To work a reverse-engineered DCF model, here are some numbers that we’d 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 figure – the share price – that we require.

Over the last 12 months, S&P Capital IQ has StarHub’s weighted average share count and free cash flow of 1.728 billion and S$244.8 million (S$556.7 million in cash flow from operations and S$311.9 million in capital expenditures), respectively. This puts StarHub’s free cash flow per share at S$0.142

In case you’re wondering what the fuss on free cash flow is all about, it is the actual cash brought in by a company’s operations that’s left after the firm has spent the necessary capital needed to maintain its businesses at their current state (this is known as capital expenditures).

The company can then use its free cash flows to benefit shareholders in a number of different ways such as paying dividends, buying back stock, strengthening the balance sheet, and investing for future growth.

Coming to the discount rate, I’ll keep things simple and stick to a hurdle rate (essentially the rate of return an investor will require) of 15%. Bear in mind though that the more academically-accepted version of the discount rate takes into account many other factors like the rate of return on a risk-free investment and the historical volatility of the stock.

As for the terminal growth rate, Singapore’s rate of inflation over the long-term, which is between 2% and 3%, can be a good proxy. I’ll go with 3% here.

Putting together all that we know thus far, this is what we have:

  • Current share price: S$3.59
  • Free cash flow per share over the last 12 months: S$0.142
  • A discount rate: 15%
  • A terminal growth rate for the company’s cash flows: 3%

With the numbers just above, we can then play around with the growth rates for StarHub’s free cash flows over the next 10 years. Based on my own number crunching, the market expects StarHub’s free cash flow per share to step up at annual rates of 25% for the first five year block and 12.5% for the next five.

A Fool’s take

It’s important to note that a reverse-engineered DCF model is not a fool-proof way to think about a company’s value. It comes with important problems, such as having the need for investors to come up with their own discount rates and the terminal growth rate.

But, the model is still helpful, as it cajoles us to think about the following question with every stock: “What’s priced in?” Being able to answer that is very useful as it juxtaposes the market’s expectations with our own assessment of a company’s growth potential.

Coming back to StarHub, are its implied growth rates reasonable enough to make its shares a bargain? That’s something each investor would have to decide on his or her own. Let me know your thoughts 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.