Yahoo Finance Is There An Opportunity With Scales Corporation Limited's (NZSE:SCL) 44% Undervaluation?
Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Scales Corporation Limited (NZSE:SCL) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
Check out our latest analysis for Scales
Is Scales fairly valued?
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. In the first stage we need to estimate the cash flows to the business over the next ten years. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) forecast
2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | |
Levered FCF (NZ$, Millions) | NZ$42.2m | NZ$49.1m | NZ$55.1m | NZ$60.2m | NZ$64.6m | NZ$68.4m | NZ$71.7m | NZ$74.8m | NZ$77.5m | NZ$80.2m |
Growth Rate Estimate Source | Est @ 22.13% | Est @ 16.27% | Est @ 12.17% | Est @ 9.3% | Est @ 7.29% | Est @ 5.88% | Est @ 4.9% | Est @ 4.21% | Est @ 3.73% | Est @ 3.39% |
Present Value (NZ$, Millions) Discounted @ 7.4% | NZ$39.3 | NZ$42.6 | NZ$44.5 | NZ$45.2 | NZ$45.2 | NZ$44.5 | NZ$43.5 | NZ$42.2 | NZ$40.8 | NZ$39.2 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NZ$426m
After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.6%. We discount the terminal cash flows to today's value at a cost of equity of 7.4%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = NZ$80m× (1 + 2.6%) ÷ (7.4%– 2.6%) = NZ$1.7b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= NZ$1.7b÷ ( 1 + 7.4%)10= NZ$837m
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$1.3b. 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$5.0, the company appears quite good value at a 44% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
Important assumptions
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Scales 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 7.4%, 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.
Moving On:
Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Scales, we've compiled three further aspects you should further research:
Risks: For instance, we've identified 2 warning signs for Scales that you should be aware of.
Future Earnings: How does SCL'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.
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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NZSE every day. If you want to find the calculation for other stocks 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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