Estimating The Intrinsic Value Of System Integrator Corp. (TSE:3826)

Key Insights

• The projected fair value for System Integrator is JP¥350 based on 2 Stage Free Cash Flow to Equity
• System Integrator's JP¥358 share price indicates it is trading at similar levels as its fair value estimate
• System Integrator's peers seem to be trading at a higher premium to fair value based onthe industry average of -13%

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of System Integrator Corp. (TSE:3826) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

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 still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

View our latest analysis for System Integrator

Crunching The Numbers

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (¥, Millions)	JP¥165.5m	JP¥175.0m	JP¥182.1m	JP¥187.5m	JP¥191.5m	JP¥194.5m	JP¥196.8m	JP¥198.6m	JP¥200.0m	JP¥201.2m
Growth Rate Estimate Source	Est @ 8.09%	Est @ 5.74%	Est @ 4.10%	Est @ 2.94%	Est @ 2.14%	Est @ 1.58%	Est @ 1.18%	Est @ 0.90%	Est @ 0.71%	Est @ 0.58%
Present Value (¥, Millions) Discounted @ 5.2%	JP¥157	JP¥158	JP¥156	JP¥153	JP¥149	JP¥143	JP¥138	JP¥132	JP¥127	JP¥121

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = JP¥1.4b

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 (0.3%) 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 5.2%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = JP¥201m× (1 + 0.3%) ÷ (5.2%– 0.3%) = JP¥4.1b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= JP¥4.1b÷ ( 1 + 5.2%)¹⁰= JP¥2.4b

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¥3.9b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of JP¥358, 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.

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 System Integrator 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 5.2%, which is based on a levered beta of 0.995. 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.

Next Steps:

Although the valuation of a company is important, it 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. For System Integrator, we've compiled three essential items you should further examine:

1. Risks: Be aware that System Integrator is showing 2 warning signs in our investment analysis , you should know about...
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. 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.