Skellerup Holdings Limited's (NZSE:SKL) Intrinsic Value Is Potentially 26% Below Its Share Price

Key Insights

• Skellerup Holdings' estimated fair value is NZ$3.18 based on 2 Stage Free Cash Flow to Equity

• Current share price of NZ$4.28 suggests Skellerup Holdings is potentially 35% overvalued

How far off is Skellerup Holdings Limited (NZSE:SKL) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by estimating the company's future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

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.

See our latest analysis for Skellerup Holdings

Is Skellerup Holdings Fairly Valued?

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. To begin with, we have to get estimates of the next ten years of cash flows. 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, 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 (NZ$, Millions)	NZ$34.9m	NZ$35.0m	NZ$35.4m	NZ$35.9m	NZ$36.5m	NZ$37.2m	NZ$37.9m	NZ$38.7m	NZ$39.5m	NZ$40.4m
Growth Rate Estimate Source	Est @ -0.33%	Est @ 0.47%	Est @ 1.02%	Est @ 1.41%	Est @ 1.68%	Est @ 1.87%	Est @ 2.00%	Est @ 2.09%	Est @ 2.16%	Est @ 2.20%
Present Value (NZ$, Millions) Discounted @ 7.6%	NZ$32.4	NZ$30.2	NZ$28.4	NZ$26.7	NZ$25.2	NZ$23.9	NZ$22.6	NZ$21.5	NZ$20.4	NZ$19.4

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NZ$251m

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 7.6%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = NZ$40m× (1 + 2.3%) ÷ (7.6%– 2.3%) = NZ$776m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= NZ$776m÷ ( 1 + 7.6%)¹⁰= NZ$372m

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$623m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of NZ$4.3, the company appears potentially overvalued at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf

The Assumptions

We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual 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 Skellerup Holdings 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 7.6%, which is based on a levered beta of 1.065. 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 Skellerup Holdings

Strength

• Debt is not viewed as a risk.

Weakness

• Earnings growth over the past year underperformed the Machinery industry.

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

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

Opportunity

• Annual earnings are forecast to grow for the next 4 years.

Threat

• Dividends are not covered by cash flow.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching 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. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. Can we work out why the company is trading at a premium to intrinsic value? For Skellerup Holdings, we've put together three relevant elements you should further examine:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Skellerup Holdings , and understanding it should be part of your investment process.

2. Future Earnings: How does SKL'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.

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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.