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Is Service Stream Limited (ASX:SSM) Trading At A 46% Discount?

Key Insights

  • The projected fair value for Service Stream is AU$1.69 based on 2 Stage Free Cash Flow to Equity

  • Current share price of AU$0.92 suggests Service Stream is potentially 46% undervalued

  • Analyst price target for SSM is AU$1.10 which is 35% below our fair value estimate

Does the January share price for Service Stream Limited (ASX:SSM) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

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View our latest analysis for Service Stream

Crunching The Numbers

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. 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$46.3m

AU$64.9m

AU$58.6m

AU$63.5m

AU$65.2m

AU$66.0m

AU$67.0m

AU$68.2m

AU$69.4m

AU$70.7m

Growth Rate Estimate Source

Analyst x4

Analyst x4

Analyst x3

Analyst x2

Analyst x1

Est @ 1.27%

Est @ 1.51%

Est @ 1.68%

Est @ 1.80%

Est @ 1.89%

Present Value (A$, Millions) Discounted @ 7.7%

AU$43.0

AU$56.0

AU$47.0

AU$47.3

AU$45.0

AU$42.4

AU$39.9

AU$37.7

AU$35.6

AU$33.7

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$428m

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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 7.7%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = AU$71m× (1 + 2.1%) ÷ (7.7%– 2.1%) = AU$1.3b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$1.3b÷ ( 1 + 7.7%)10= AU$614m

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is AU$1.0b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of AU$0.9, the company appears quite undervalued at a 46% 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.

dcf
ASX:SSM Discounted Cash Flow January 15th 2024

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 Service Stream 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 7.7%, which is based on a levered beta of 1.120. 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 Service Stream

Strength

  • Debt is well covered by cash flow.

Weakness

  • Interest payments on debt are not well covered.

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

Opportunity

  • Annual earnings are forecast to grow faster than the Australian market.

  • Trading below our estimate of fair value by more than 20%.

Threat

  • Dividends are not covered by earnings.

  • Annual revenue is forecast to grow slower than the Australian market.

Next Steps:

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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Why is the intrinsic value higher than the current share price? For Service Stream, we've put together three essential elements you should explore:

  1. Risks: As an example, we've found 1 warning sign for Service Stream that you need to consider before investing here.

  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for SSM's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

  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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the ASX every day. If you want to find the calculation for other stocks 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.