Over the weekend, I was with a bunch of my friends when one of them mentioned that Singapore’s smallest telecommunications outfit M1 Ltd (SGX: B2F) has fallen drastically over the past year. True enough, when I pulled up some numbers from S&P Capital IQ for M1, I found that the telco had declined by 38% from S$3.78 on 2 February 2015 to merely S$2.33 currently. It’s a sharp drop that is also way more drastic than the 23% fall experienced by Singapore’s market barometer, the Straits Times Index (SGX: ^STI), over the same period. Could M1 possibly be a cheap…
Over the weekend, I was with a bunch of my friends when one of them mentioned that Singapore’s smallest telecommunications outfit M1 Ltd (SGX: B2F) has fallen drastically over the past year.
True enough, when I pulled up some numbers from S&P Capital IQ for M1, I found that the telco had declined by 38% from S$3.78 on 2 February 2015 to merely S$2.33 currently. It’s a sharp drop that is also way more drastic than the 23% fall experienced by Singapore’s market barometer, the Straits Times Index (SGX: ^STI), over the same period.
Could M1 possibly be a cheap share now after its large fall? I thought I’d use a reverse-engineered discounted cash flow model to find out.
Going on reverse in the quest for value
When investors want to value a company, one tool they can use is a discounted cash flow (DCF) model. What the model does is it estimates all the cash that a company can churn out over its lifetime, sums all that cash up, and discounts them back to the present.
For companies that produce steady cash flows – such as M1 – a DCF model can be appropriate. But, this traditional DCF model has some hairy issues to overcome.
A popular way for investors to determine the life-time cash that a company can produce is done in two steps: (1) Predict how fast a company can grow its free cash flows over the next 10 years and (2) estimate how fast the company’s free cash flow can grow from the 11th year onward in perpetuity (this growth rate is known as the terminal growth rate).
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 determine the implied growth rates of a stock at a particular stock price rather than try to estimate the growth rates needed – helps alleviate some of the problems that come with a traditional DCF model. An investor can then use the implied growth rates and consider how reasonable those rates are.
That’s why I’m using a reverse-engineered DCF model here with M1.
M1: A value stock or not
The following are some vital inputs for a reverse-engineered DCF model:
- 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 already have M1’s current share price. Meanwhile, FCF is an important number in the word of investing. 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 then use its FCF to benefit its shareholders in a number of different ways such as buying back stock, strengthening the balance sheet, investing for growth, or paying dividends.
For the discount rate, I’d keep things simple and stick to my own required rate of return (this is also known as a hurdle rate) of 15%. It’s worth noting that the discount rate can also take on a more complex form that takes into account the current rate of return of a risk-free investment and the historical volatility of the stock in question.
Coming to the terminal growth rate, the long-run rate of inflation in Singapore, which has been between 2% and 3%, can be a good proxy. I’d be using 3% for this exercise.
So, to summarise, here’s what we have so far for M1:
- Current share price: S$2.33
- FCF per share over last 12 months: S$0.113
- Discount rate: 15%
- Terminal growth rate: 3%
With these figures, I can then play around with the growth rates for M1’s free cash flows per share over the next 10 years. Based on my number crunching and earlier assumptions, the implied growth rates for M1’s free cash flows are 21% for the first five year block and 10.5% for the next five.
A Fool’s take
A reverse-engineered DCF model is far from being a perfect valuation tool. Some of you might realise that the model also required me to come up with my own discount rate and terminal growth rate. But, the model’s usefulness lies in the idea that we’re being prodded to ask what’s priced in with a stock each time we use it.
In the case of M1, do you think that its implied free cash flow growth rates at its current stock price are reasonable? 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 companies mentioned.