With so many different financial models generating different conclusions, choosing the most relevant one to value a company can be daunting. In the case of SEB SA’s (EPA:SK), my discounted cash flow (DCF) model tells me that SEB SA’s (EPA:SK) is overvalued by 6.65%; however, my relative valuation metrics tell me that SEB SA’s (EPA:SK) is overvalued by 51.8%. Which model do I listen to and more importantly why?
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Examining intrinsic valuation
The DCF model follows the principle that a firm’s “true” value today is equal to the sum of all its the future free cash flows (FCF) it will make in the future (to infinity). Since the hardest part of constructing a DCF is forecasting this, I’ve decided to use the average expected FCF forecasted by broker analysts in my model. To obtain the per share intrinsic value of SK, we must first discount the sum of SK’s future FCFs by 11%, which gives us an equity value of €€5.8b, then 49.67k shares outstanding are divided through. This results in an intrinsic value of €117.3. Take a look at how I arrived at this intrinsic value here.,
But how dependable is this value? Since it is generally impossible to forecast FCFs indefinitely, it is common for analysts to forecast for an explicit forecast horizon and then assume the company is mature by the end of that period and in a stable growth phase. SK’s final year FCF growth rate of -0.49%, is too low. If this assumption held true, SK would shrink to a point where it would cease to exist very soon, which is a highly unlikely outcome. To improve our DCF analysis, we could extend the terminal year until FCF growth moderates to a more sustainable level around 1% to 5%. However, the trade-off is that there are less analyst forecasts the further in the future we go.
Examining relative valuation
While DCF models sum up future FCFs, relative valuation models are based on the idea that investors should pay the same price for two companies with identical risk and return profiles. Since the biggest dilemma is finding companies that are similar to SK, a viable proxy would be the overall Consumer Durables industry itself. Obtaining the fair value of SK through relative valuation is quite straightforward. We simply multiply SK’s earnings by the industry’s P/E ratio, which gives us a share price of €60.3 that implies SK is currently overvalued. However, is this conclusion robust enough for us to use?
To check the robustness of our relative valuation, let’s take a look at if SK has a similar growth profile to the overall Consumer Durables industry. At 11.29% earnings growth next year, SK has a dramatically different earnings growth profile to the overall Consumer Durables industry, which is expected to grow at 4.63%. This demonstrates that the Consumer Durables industry is a weak proxy for SK, which undermines our relative valuation analysis. Instead, we could dramatically improve our analysis by hand-picking companies that share similar growth profiles with SK. I’d encourage you to do this by taking a look at SK’s competitors.
Which Model Is Superior?
Neither model is perfect despite the robust financial theory behind them. Relative valuation is straightforward but prone to overall market mispricing. Meanwhile, intrinsic valuation is independent from market tendencies; however, is highly exposed to human error. Ultimately, investors should derive their final valuation based off both models. I encourage you to weight each model depending on your preferences to calculate a weighted average target price.
For SK, there are three important aspects you should further examine:
- Financial Health: Does SK have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does SK’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 High Quality Alternatives: Are there other high quality stocks you could be holding instead of SK? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. The Simply Wall St app conducts a discounted cash flow for every stock on the EPA every 6 hours. If you want to find the calculation for other stocks just search here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.