Does the January price of Sasol Limited (JSE:SOL) share reflect what it is really worth? Today we are going to estimate the intrinsic value of the stock by taking the expected future cash flows and discounting them to their present value. This will be done using the discounted cash flow (DCF) model. Believe it or not, it’s not too hard to follow, as you’ll see in our example!

We draw your attention to the fact that there are many ways to value a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in learning a little more about intrinsic value should read the Simply Wall St.

Check out our latest analysis for Sasol

The method

We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “sustained growth”. To begin with, we need to obtain cash flow estimates for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.

A DCF is based on the idea that a dollar in the future is worth less than a dollar today, and so the sum of these future cash flows is then discounted to today’s value:

Estimated free cash flow (FCF) over 10 years

(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = R171b

The second stage is also known as the terminal value, it is the cash flow of the business after the first stage. For a number of reasons, a very conservative growth rate is used which cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (8.8%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 17%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = R64b × (1 + 8.8%) ÷ (17% – 8.8%) = R815b

Present value of terminal value (PVTV)= TV / (1 + r)^ten= R815b÷ ( 1 + 17%)^ten= R164b

The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is R335b. The final step is to divide the equity value by the number of shares outstanding. Compared to the current share price of R304, the company seems to have a pretty good value with a 43% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.

Important assumptions

Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flows. If you disagree with these results, try the math yourself and play around with the assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Sasol 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 takes debt into account. In this calculation, we used 17%, which is based on a leveraged beta of 1.234. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

Look forward:

Valuation is only one side of the coin in terms of crafting 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. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on the valuation. Why is intrinsic value higher than the current stock price? For Sasol, we have compiled three important elements that you should consider in more detail:

1. Risks: Know that Sasol shows 2 warning signs in our investment analysis , you should know…
2. Future earnings: How does SOL’s growth rate compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
3. Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of ​​what you might be missing!

PS. Simply Wall St updates its DCF calculation for every South African stock daily, so if you want to find the intrinsic value of any other stock, just search here.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.