Are Sims Limited (ASX:SGM) Investors Paying Above The Intrinsic Value?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Sims fair value estimate is AU$10.86

• Current share price of AU$14.42 suggests Sims is potentially 33% overvalued

• The AU$15.15 analyst price target for SGM is 40% more than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of Sims Limited (ASX:SGM) by estimating the company's future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. It may sound complicated, but actually it is quite simple!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Sims

The Calculation

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. To begin with, we have to get estimates of 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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	AU$156.5m	AU$211.0m	AU$178.2m	AU$159.9m	AU$149.3m	AU$143.3m	AU$140.2m	AU$138.8m	AU$138.8m	AU$139.6m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Est @ -15.55%	Est @ -10.28%	Est @ -6.59%	Est @ -4.01%	Est @ -2.21%	Est @ -0.94%	Est @ -0.06%	Est @ 0.56%
Present Value (A$, Millions) Discounted @ 8.4%	AU$144	AU$180	AU$140	AU$116	AU$99.9	AU$88.5	AU$79.8	AU$73.0	AU$67.3	AU$62.4

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$1.1b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 8.4%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$140m× (1 + 2.0%) ÷ (8.4%– 2.0%) = AU$2.2b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$2.2b÷ ( 1 + 8.4%)¹⁰= AU$1.0b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$2.1b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of AU$14.4, the company appears potentially overvalued at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Sims 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 8.4%, which is based on a levered beta of 1.273. 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.

SWOT Analysis for Sims

Strength

• Debt is not viewed as a risk.

• Dividends are covered by earnings and cash flows.

Weakness

• Earnings growth over the past year underperformed the Metals and Mining industry.

• Dividend is low compared to the top 25% of dividend payers in the Metals and Mining market.

• Expensive based on P/E ratio and estimated fair value.

Opportunity

• SGM's financial characteristics indicate limited near-term opportunities for shareholders.

Threat

• Annual earnings are forecast to decline for the next 3 years.

Next Steps:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price exceeding the intrinsic value? For Sims, we've put together three relevant factors you should assess:

1. Risks: Every company has them, and we've spotted 3 warning signs for Sims (of which 1 is potentially serious!) you should know about.

2. Future Earnings: How does SGM'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 Australian stock every day, so if you want to find the intrinsic value of any other stock just search here.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.