Investors Are Undervaluing Johnson Electric Holdings Limited (HGK:179) By 31.65%

In this article I am going to calculate the intrinsic value of Johnson Electric Holdings Limited (HGK:179) by taking the expected future cash flows and discounting them to their present value. I will be using the discounted cash flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. If you want to learn more about discounted cash flow, the basis for my calcs can be read in detail in the Simply Wall St analysis model. If you are reading this and its not June 2018 then I highly recommend you check out the latest calculation for Johnson Electric Holdings by following the link below. See our latest analysis for Johnson Electric Holdings

Step by step through the calculation

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 five years of cash flows. Where possible I use analyst estimates, but when these aren’t available I have extrapolated the previous free cash flow (FCF) from the year before. For this growth rate I used the average annual growth rate over the past five years, but capped at a reasonable level. The sum of these cash flows is then discounted to today’s value.

5-year cash flow estimate

2018 2019 2020 2021 2022
Levered FCF ($, Millions) $85.05 $86.00 $225.85 $284.00 $312.46
Source Analyst x2 Analyst x1 Analyst x2 Analyst x1 Extrapolated @ (10.02%)
Present Value Discounted @ 8.44% $78.43 $73.13 $177.11 $205.38 $208.37

Present Value of 5-year Cash Flow (PVCF)= $742.42

The second stage is also known as Terminal Value, this is the business’s cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 2.2%. We discount this to today’s value at a cost of equity of 8.4%.

Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = $312.46 × (1 + 2.2%) ÷ (8.4% – 2.2%) = $5.12k

Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = $5.12k / ( 1 + 8.4%)5 = $3.41k

The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is $4.16k. In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number. This results in an intrinsic value in the company’s reported currency of $4.82. However, 179’s primary listing is in Hong Kong, and 1 share of 179 in USD represents 7.845 ( USD/ HKD) share of OTCPK:JELC.F, so the intrinsic value per share in HKD is HK$37.82. Compared to the current share price of HK$25.85, the stock is quite good value at a 31.65% discount to what it is available for right now.

SEHK:179 Intrinsic Value June 11th 18
SEHK:179 Intrinsic Value June 11th 18

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 don’t agree with my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Johnson Electric Holdings as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 8.4%, which is based on a levered beta of 0.800. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

Next Steps:

Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For 179, there are three key aspects you should further examine:

  1. Financial Health: Does 179 have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
  2. Future Earnings: How does 179’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 High Quality Alternatives: Are there other high quality stocks you could be holding instead of 179? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. The Simply Wall St app conducts a discounted cash flow for every stock on the HGK every 6 hours. If you want to find the calculation for other stocks just search here.