If you haven’t already heard, the stock market has been a tough place to be over the past few months. Since peaking at 3,550 points on April 2015, the Straits Times Index (SGX: ^STI) is down by 27% at its current level of 2,593.
While it may be natural to associate falling stock prices with the appearance of bargains, it’s also worth noting that not every fallen stock may be an investing opportunity. Keeping this in mind, can investors call Singapore Technologies Engineering Ltd (SGX: S63), Singapore Exchange Limited (SGX: S68), and StarHub Ltd (SGX: CC3) legitimate bargains?
The trio are all blue chip stocks as they are part of the 30 companies which make up the Straits Times Index. They have all also fallen hard since the start of 1 April 2015 as you can see in the table below:
To get a better grasp of whether ST Engineering, Singapore Exchange, and StarHub are bargains or not, we can look at their current share prices to figure out the growth rates in their businesses that are implied by the market.
Seeking value in reverse
Before we dive into the numbers with the three companies, let’s have a few words first about what we’re trying to do here.
When investors value a company, they can do so using a discounted cash flow (DCF) model. What the model does is it estimates all the cash that a company can produce over its lifetime, sums them up, and then discounts them back to the present.
A popular way for investors to determine the cash that can be produced 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 the company can grow its free cash flows from the 11th year onward in perpetuity; this growth rate is known as the terminal growth rate.
A forward-looking DCF model like the one I had just described, while useful, has its issues. In his book Value Investing, investor James Montier wrote that DCF models have “problems with estimating cash flows, and problems with estimating the discount rate.”
A reverse-engineered DCF model – which seeks to figure out the implied growth rates for a company’s free cash flow at a certain share price – helps alleviate some of the important problems with a traditional forward-looking DCF model.
That is why we are working backwards with our aforementioned trio of stocks to determine if there’s any value in them.
To work a reverse-engineered DCF model, the following are some crucial inputs that we need about each share:
- Current share price
- Free cash flow (FCF) per share over the last 12 months
- A discount rate
- A terminal growth rate for the company’s free cash flow
We can easily obtain the share prices for our trio.
Meanwhile, the FCF number is important in an investing context – it is the actual cash brought in by a company after the necessary capital has been spent to maintain the firm’s businesses at their current state.
A company can use its FCF to benefit its shareholders in a number of different ways such as paying dividends, buying back stock, investing in growth opportunities, or strengthening the balance sheet.
For the discount rate, I’d stick to my own required rate of return of 15% for the three blue chips we’re looking at. This is also known as a hurdle rate. It’s worth noting that a discount rate can also take on a more complex form which accounts for the current rate of return for a risk-free investment and the historical volatility of the stock(s) in question.
As for the terminal growth rate, we can use the long-run rate of inflation in Singapore, which comes in between 2% and 3%, as a close proxy. I’d stick with 3% here for the three stocks we’re interested in.
So, let’s pull all the crucial inputs we need into the table below:
Using these figures, we can then play around with the growth rates for the three stocks’ free cash flows over the next 10 years (the 10 year period is split into two five-year blocks). Based on my own number crunching, here are the implied growth rates in free cash flow for the trio:
A Fool’s take
Even a reverse-engineered DCF model has its flaws. For instance, investors will have to come up with their own discount rates and terminal growth rates. But, a reverse-engineered DCF model can still prod investors to ask, “What is priced in?” That can be a very helpful thought to have.
Coming to the trio of ST Engineering, Singapore Exchange, and StarHub, do the implied growth rates for their respective free cash flows look reasonable to you? This is where you’d have to use your own judgement. 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.