A look at the intrinsic value of SSE plc (LON:SSE)

Key findings

• The forecast fair value for SSE is £16.14 based on the dividend discount model

• The current share price of GBP 17.90 suggests that SSE may be trading close to its fair value.

• The analyst price target of GBP 21.10 for SSE is 31% above our fair value estimate

Does the SSE plc (LON:SSE) share price in June reflect its true value? Today we will estimate the intrinsic value of the stock by taking the company’s forecast future cash flows and discounting them to today’s value. This is done using the Discounted Cash Flow (DCF) model. It’s actually not a big effort, even though it may seem quite complex.

We generally believe that the value of a company is the present value of all the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without its flaws. If you want to learn more about discounted cash flow, you can read the basics of this calculation in detail in Simply Wall St’s analysis model.

Check out our latest analysis for SSE

Processing the numbers

We need to calculate the value of SSE slightly differently to other stocks because it’s an electricity supply company. This approach uses dividends per share (DPS) because free cash flow is difficult to estimate and often not reported by analysts. This often underestimates the value of a stock, but it can still be a good comparison to competitors. It uses the ‘Gordon Growth Model’, which simply assumes that dividend payments will continue to grow at a sustainable growth rate forever. For a number of reasons, a very conservative growth rate is used, which cannot exceed that of a company’s gross domestic product (GDP). In this case, we’ve used the 5-year average 10-year Treasury bond yield (1.8%). The expected dividend per share is then discounted to today’s value using a cost of equity of 6.2%. Relative to the current share price of £17.9, the company appears to be around fair value at the time of writing. However, ratings are imprecise instruments, much like a telescope – move a few degrees and you end up in a different galaxy. Keep that in mind.

The story goes on

Value per share = Expected dividend per share / (Discount rate – Perpetual growth rate)

= 0.7 GBP / (6.2% – 1.8%)

= 16.1 GBP

The assumptions

The key inputs to a discounted cash flow are the discount rate and of course the actual cash flows. If you don’t agree with these results, try the calculation yourself and play with the assumptions. DCF also doesn’t take into account the potential cyclicality of an industry or a company’s future capital needs and therefore doesn’t provide a complete picture of a company’s potential performance. Since we consider SSE 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 6.2%, which is based on a leveraged beta of 0.800. Beta is a measure of a stock’s volatility relative to the overall market. We get our beta from the industry average beta of globally comparable companies, with a set limit between 0.8 and 2.0, which is a reasonable range for a stable company.

SWOT Analysis for SSE

Strength

weakness

Opportunity

Danger

Next Steps:

While important, ideally the DCF calculation should not be the only analysis you consider for a company. DCF models are not the be-all and end-all of investment valuation. Rather, they should be viewed as a guide to “what assumptions need to hold for this stock to be under/overvalued.” If a company grows differently, or its cost of equity or risk-free rate changes significantly, the outcome may look very different. For SSE, we have compiled three basic factors you should evaluate:

1. Risks: Note that SSE shows 3 warning signals in our investment analysis you should know about…

2. Future income: How is SSE’s growth rate compared to competitors and the overall market? Learn more about analyst consensus numbers for the coming years by using our free chart of analyst growth expectations.

3. Other high-quality alternatives: Like a good all-rounder? Explore our interactive list of high-quality stocks to get a sense of what else you might be missing out on!

PS Simply Wall St updates its DCF calculation for each UK stock daily, so if you want to find out the intrinsic value of another stock, just search here.

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This Simply Wall St article is of a general nature. We comment solely on historical data and analyst forecasts, using an unbiased methodology. Our articles do not constitute financial advice. It is not a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. Our goal is to provide you with long-term analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative materials. Simply Wall St does not hold any of the stocks mentioned.

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