Is There An Opportunity With Tokyo Steel Manufacturing Co., Ltd.'s (TSE:5423) 46% Undervaluation?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Tokyo Steel Manufacturing fair value estimate is JP¥2,861
• Tokyo Steel Manufacturing is estimated to be 46% undervalued based on current share price of JP¥1,548
• Analyst price target for 5423 is JP¥1,983 which is 31% below our fair value estimate

Does the May share price for Tokyo Steel Manufacturing Co., Ltd. (TSE:5423) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out our latest analysis for Tokyo Steel Manufacturing

The Model

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (¥, Millions)	JP¥27.2b	JP¥11.1b	JP¥21.2b	JP¥23.8b	JP¥24.2b	JP¥22.2b	JP¥21.0b	JP¥20.2b	JP¥19.7b	JP¥19.3b
Growth Rate Estimate Source	Analyst x4	Analyst x3	Analyst x5	Analyst x4	Analyst x3	Analyst x2	Est @ -5.49%	Est @ -3.79%	Est @ -2.59%	Est @ -1.75%
Present Value (¥, Millions) Discounted @ 6.6%	JP¥25.6k	JP¥9.8k	JP¥17.5k	JP¥18.4k	JP¥17.6k	JP¥15.2k	JP¥13.5k	JP¥12.1k	JP¥11.1k	JP¥10.2k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = JP¥151b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (0.2%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 6.6%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = JP¥19b× (1 + 0.2%) ÷ (6.6%– 0.2%) = JP¥305b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= JP¥305b÷ ( 1 + 6.6%)¹⁰= JP¥161b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is JP¥312b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of JP¥1.5k, the company appears quite undervalued at a 46% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

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 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 Tokyo Steel Manufacturing 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 6.6%, which is based on a levered beta of 1.129. 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 Tokyo Steel Manufacturing

Moving On:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. 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. Can we work out why the company is trading at a discount to intrinsic value? For Tokyo Steel Manufacturing, we've compiled three additional items you should further examine:

1. Risks: We feel that you should assess the 2 warning signs for Tokyo Steel Manufacturing (1 shouldn't be ignored!) we've flagged before making an investment in the company.
2. Future Earnings: How does 5423'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: Do you like a good all-rounder? 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 valuation for every stock on the TSE 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.