StarHub Ltd (SGX: CC3) is one of the three main telecommunications services providers in Singapore. At StarHub’s share price of S$1.59 right now, is the company a bargain or an expensive stock?
One way to value companies would be to use the Discounted Cash Flow (DCF) method.
DCF: A quick primer
A DCF model essentially sums up all the cash a company can produce over its lifetime before discounting them back to the present value.
The popular way to estimate that amount of cash would be to first determine how fast a company can grow its free cash flows over the next 10 years. This is followed by estimating how fast the company can grow its free cash flows from the 11th year onward to perpetuity; this is known as the terminal growth rate.
However, there are issues with using a DCF model.
For instance, investors need to estimate how much cash a company can produce – in essence, investors need to project a company’s future cash flows but the future can be hard to predict. To counter some of those roadblocks, we can use a reverse-engineered DCF model instead. The reverse-engineered DCF model looks at a stock’s current price to determine the implied free cash flow growth rates the market expects from the stock.
To produce a reverse-engineered DCF model for StarHub, some of the starting ingredients required are:
- StarHub’s current share price
- StarHub’s free cash flow per share generated over the last 12 months
- A discount rate
- A terminal growth rate for StarHub’s free cash flows
As mentioned earlier, StarHub’s current share price is S$1.59. The company’s trailing free cash flow per share is S$0.10 (free cash flow of S$173.8 million in 2018 divided by a share count of 1.73 billion).
For the discount rate, we would be using a required rate of return (also known as the hurdle rate), which is set at 15%. Do note that there’s a more complicated way to calculate the discount rate, but we are keeping things simple here.
Coming to the terminal growth rate, we would simply set it at the historical rate of long-term inflation, which is around 2% to 3% for Singapore. We will use the more conservative 3% here.
So, to sum up what we have at the moment:
- StarHub’s current share price: S$1.59
- StarHub’s free cash flow per share generated over the last 12 months: S$0.10
- Discount rate: 15%
- Terminal growth rate for StarHub’s free cash flows: 3%
With the figures just above, our calculations show that the market expects StarHub’s free cash flow per share to grow by around 16% annually over the next five years, and then by around 8% over the subsequent five-year block.
So, is StarHub undervalued?
We can then use the implied growth rates for StarHub’s free cash flow growth and compare it with our own views on the company’s ability to grow. If you think the implied growth rates are too low for StarHub, then the company would be a bargain at its current share price of S$1.59. But, if you think the implied growth rates are way too ambitious a target, then StarHub could be an incredibly over-priced stock right now.
I think it might be a tall order for StarHub to achieve the implied growth rates in my reverse-DCF model (16% annual growth for the upcoming five years, and 8% annual growth in the subsequent five years). This is because StarHub’s free cash flow has not been growing anywhere near those rates in the past few years. In fact, StarHub’s free cash flow has fallen from S$333.3 million in 2014 to S$173.8 million in 2018. There is also increasing competition in the industry StarHub is in.
Therefore, I think StarHub is not cheap right now, even though its share price has plunged by 64% from a high of S$4.46 in April 2015 to S$1.59 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 contributor Sudhan P doesn’t own shares in any companies mentioned.