Estimating The Intrinsic Value Of LEC, Inc. (TSE:7874)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, LEC fair value estimate is JP¥1,185
• LEC's JP¥1,217 share price indicates it is trading at similar levels as its fair value estimate
• LEC's peers seem to be trading at a lower premium to fair value based onthe industry average of -1.0%

Does the April share price for LEC, Inc. (TSE:7874) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the forecast future cash flows of the company and discounting them back to today's 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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

We've discovered 2 warning signs about LEC. View them for free.

The Method

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To start off with, we need to estimate the next ten years of cash flows. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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) estimate

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (¥, Millions)	JP¥3.49b	JP¥3.51b	JP¥3.53b	JP¥3.55b	JP¥3.57b	JP¥3.58b	JP¥3.60b	JP¥3.61b	JP¥3.63b	JP¥3.64b
Growth Rate Estimate Source	Est @ 0.74%	Est @ 0.63%	Est @ 0.55%	Est @ 0.50%	Est @ 0.46%	Est @ 0.43%	Est @ 0.41%	Est @ 0.40%	Est @ 0.39%	Est @ 0.39%
Present Value (¥, Millions) Discounted @ 9.9%	JP¥3.2k	JP¥2.9k	JP¥2.7k	JP¥2.4k	JP¥2.2k	JP¥2.0k	JP¥1.9k	JP¥1.7k	JP¥1.6k	JP¥1.4k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = JP¥22b

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 0.4%. We discount the terminal cash flows to today's value at a cost of equity of 9.9%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = JP¥3.6b× (1 + 0.4%) ÷ (9.9%– 0.4%) = JP¥38b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= JP¥38b÷ ( 1 + 9.9%)¹⁰= JP¥15b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is JP¥37b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of JP¥1.2k, the company appears around fair value at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 LEC 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 9.9%, which is based on a levered beta of 1.802. 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.

View our latest analysis for LEC

SWOT Analysis for LEC

Looking Ahead:

Whilst important, the DCF calculation 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. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For LEC, there are three relevant factors you should explore:

1. Risks: Case in point, we've spotted 2 warning signs for LEC you should be aware of.
2. 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!
3. Other Environmentally-Friendly Companies: Concerned about the environment and think consumers will buy eco-friendly products more and more? Browse through our interactive list of companies that are thinking about a greener future to discover some stocks you may not have thought of!

PS. Simply Wall St updates its DCF calculation for every Japanese stock every day, so if you want to find the intrinsic value of any other stock 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.