Estimating The Intrinsic Value Of Spark New Zealand Limited (NZSE:SPK)

Does the February share price for Spark New Zealand Limited (NZSE:SPK) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by projecting its future cash flows and then discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out our latest analysis for Spark New Zealand

The calculation

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (NZ$, Millions)	NZ$582.5m	NZ$514.5m	NZ$510.0m	NZ$421.0m	NZ$422.0m	NZ$401.7m	NZ$390.9m	NZ$386.2m	NZ$385.6m	NZ$387.8m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x2	Analyst x1	Analyst x1	Est @ -4.81%	Est @ -2.69%	Est @ -1.2%	Est @ -0.16%	Est @ 0.57%
Present Value (NZ$, Millions) Discounted @ 6.5%	NZ$547	NZ$454	NZ$423	NZ$328	NZ$309	NZ$276	NZ$252	NZ$234	NZ$220	NZ$207

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NZ$3.2b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (2.3%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 6.5%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = NZ$388m× (1 + 2.3%) ÷ (6.5%– 2.3%) = NZ$9.5b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= NZ$9.5b÷ ( 1 + 6.5%)¹⁰= NZ$5.1b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is NZ$8.3b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of NZ$4.7, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at Spark New Zealand as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which accounts for debt. In this calculation we've used 6.5%, which is based on a levered beta of 0.800. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

Next Steps:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Spark New Zealand, there are three important elements you should consider:

1. Risks: For instance, we've identified 2 warning signs for Spark New Zealand (1 shouldn't be ignored) you should be aware of.

2. Future Earnings: How does SPK's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.

3. Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

PS. Simply Wall St updates its DCF calculation for every New Zealander stock every day, so if you want to find the intrinsic value of any other stock just search here.

This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.

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