Does the May price of Sempra Energy (NYSE: SRE) stock reflect what it is really worth? Today we will estimate the intrinsic value of the security by taking expected future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Believe it or not, it’s not too hard to follow, as you will see in our example!
Remember, however, that there are many ways to estimate the value of a business and that a DCF is just one method. If you still have burning questions about this type of assessment, take a look at the Simply Wall St analysis model.
Discover our latest analysis for Sempra Energy
We have to calculate the value of Sempra Energy slightly differently from other stocks because it is an integrated utility company. Instead of using free cash flow, which is difficult to estimate and often not reported by industry analysts, Dividend Payments Per Share (DPS) are used. Unless a company pays out the majority of its FCF as a dividend, this method will generally underestimate the value of the stock. We use the Gordon Growth Model, which assumes that the dividend will grow in perpetuity at a rate that can be sustained. The dividend is expected to grow at an annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.0%. We then discount this figure to present value at a cost of equity of 5.8%. Compared to the current share price of US $ 136, the company is around fair value at the time of writing. Remember though, this is only a rough estimate, and like any complex formula – garbage in, garbage out.
Value per share = expected dividend per share / (discount rate – perpetual growth rate)
= 4.8 USD / (5.8% – 2.0%)
= $ 127
The above calculation is very dependent on two assumptions. One is the discount rate and the other is cash flow. If you don’t agree with these results, try the calculation yourself and play 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 view Sempra Energy 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 5.8%, which is based on a leverage beta of 0.800. Beta is a measure of the volatility of a stock, relative 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.
To move on:
While a business valuation is important, it shouldn’t be the only metric you look at when researching a business. The DCF model is not a perfect inventory valuation tool. Preferably, you would apply different cases and assumptions and see how they would impact 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 valuation. For Sempra Energy, there are three other aspects to consider:
- Risks: For example, we discovered 2 warning signs for Sempra Energy (1 makes us a little uncomfortable!) Which you should be aware of before investing here.
- Future income: How does SRE’s growth rate compare to its peers and to the market in general? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth forecast chart.
- Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high quality inventory to get a feel for what you might be missing!
PS. Simply Wall St updates its DCF calculation for every US stock every day, 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. It does not constitute a recommendation to buy or sell any stock, and does not take into account your goals or your financial situation. We aim to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative information. Simply Wall St has no position in the mentioned stocks.
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