Are Investors Undervaluing Pentamaster International Limited (HKG:1665) By 47%?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Pentamaster International fair value estimate is HK$1.51
• Pentamaster International is estimated to be 47% undervalued based on current share price of HK$0.80
• When compared to theindustry average discount to fair value of 63%, Pentamaster International's competitors seem to be trading at a greater discount

Today we will run through one way of estimating the intrinsic value of Pentamaster International Limited (HKG:1665) by taking the expected future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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

See our latest analysis for Pentamaster International

Is Pentamaster International Fairly Valued?

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To begin with, we have to get estimates of the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, 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) forecast

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (MYR, Millions)	RM40.2m	RM83.5m	RM108.2m	RM131.3m	RM151.8m	RM169.5m	RM184.6m	RM197.3m	RM208.3m	RM217.8m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Est @ 29.53%	Est @ 21.37%	Est @ 15.66%	Est @ 11.67%	Est @ 8.87%	Est @ 6.91%	Est @ 5.54%	Est @ 4.58%
Present Value (MYR, Millions) Discounted @ 9.6%	RM36.7	RM69.5	RM82.2	RM91.0	RM96.1	RM97.9	RM97.3	RM94.9	RM91.4	RM87.2

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = RM844m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.3%. We discount the terminal cash flows to today's value at a cost of equity of 9.6%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = RM218m× (1 + 2.3%) ÷ (9.6%– 2.3%) = RM3.1b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= RM3.1b÷ ( 1 + 9.6%)¹⁰= RM1.2b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is RM2.1b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of HK$0.8, the company appears quite good value at a 47% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Pentamaster International 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 9.6%, which is based on a levered beta of 1.297. 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 Pentamaster International

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price sitting below the intrinsic value? For Pentamaster International, we've put together three fundamental factors you should further research:

1. Risks: To that end, you should be aware of the 1 warning sign we've spotted with Pentamaster International .
2. Future Earnings: How does 1665'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the SEHK every day. If you want to find the calculation for other stocks 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.