Is SATS Ltd A Bargain Stock Now?

SATS Ltd (SGX: S58), a provider of airline food catering and ground handling services at airports, has a stock price of S$4.18 currently. Is the stock a cheap bargain, incredibly overpriced, or somewhere in between now?

One useful way to find out would be to try and determine the real value of SATS’s stock. This is where a Discounted Cash Flow (DCF) model comes into play.

A search for value

A DCF model essentially sums up all the cash a company can produce over its lifetime before discounting them back to the present.

The popular way to estimate that amount of cash would be to first predict how fast a company can grow its free cash flows over the next 10 years. This is followed by guessing how fast the company can grow its free cash flows from the 11th year onward to perpetuity; that growth rate is known as the terminal growth rate.

But, there are issues with using a traditional forward-looking DCF model. For instance, investors have to project future cash flows and the future can be hard to predict. In his book Value Investing: Tools and Techniques for Intelligent Investment, investor James Montier wrote that DCF models have “problems with estimating cash flows, and problems with estimating the discount rate.”

To counter some of these roadblocks, Montier suggested investors use a reverse-engineered DCF model instead. The reverse-engineered DCF model looks at a stock’s current price to determine what sort of growth rates the market expects a company to achieve for its free cash flow.

Getting the numbers

So, let’s run SATS through a reverse-engineered DCF model to see what turns up. Here are some of the inputs we’d require for the model:

  • The company’s current stock price
  • The free cash flow per share generated over the last 12 months
  • A discount rate
  • A terminal growth rate for the company’s free cash flows

SATS has a stock price of S$4.18, as we’ve seen. Meanwhile, data from S&P Global Market Intelligence show that the company has a trailing free cash flow per share of S$0.169 (S$188 million in free cash flow divided by 1.111 billion in outstanding shares).

I’d use my required rate of return of 15% as the discount rate here; this is also known as the hurdle rate. It’s worth noting that there are other definitions for the discount rate which takes into account the risk free rate of return, the equity risk premium, and the historical volatility of the stock in question in relation to the broader market. But, I just want to keep things simple.

As for the terminal growth rate, we can use the historical long run rate of inflation, which is around 2% to 3% in Singapore. I’d choose 3% here.

Summing up what we have:

  • The company’s current stock price: S$4.18
  • The free cash flow per share generated over the last 12 months: S$0.169
  • A discount rate: 15%
  • A terminal growth rate for the company’s free cash flows: 3%

With these numbers and some spreadsheet-crunching, I see that the market currently expects SATS’s free cash flow per share to grow at 24.6% annually over the next five years and then at 12.3% per year over the next five year block. You can see this in the table below:

SATS FCF growth rate table
Source: Author’s assumptions and calculations

The implied growth rates for SATS’s free cash flow can then be used to compare with our own views on the company’s ability to grow. If you think the implied rates for SATS are an underestimation of the company’s strengths, then SATS could be an undervalued stock at its current price of S$4.18. But on the other hand, if you think the 24.6% and 12.3% annual growth rates are a really tall order for SATS to achieve, then the company may be a very expensive stock right now.

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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.