NEC Corporation (TSE:6701) Shares Could Be 22% Below Their Intrinsic Value Estimate

Key Insights

• NEC's estimated fair value is JP¥4,140 based on 2 Stage Free Cash Flow to Equity
• NEC is estimated to be 22% undervalued based on current share price of JP¥3,225
• The JP¥3,422 analyst price target for 6701 is 17% less than our estimate of fair value

In this article we are going to estimate the intrinsic value of NEC Corporation (TSE:6701) by taking the forecast future cash flows of the company and discounting them back to today's value. Our analysis will employ 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.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

We've discovered 1 warning sign about NEC. View them for free.

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 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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (¥, Millions)	JP¥10.1b	JP¥221.1b	JP¥257.8b	JP¥291.1b	JP¥336.5b	JP¥368.2b	JP¥393.0b	JP¥411.9b	JP¥426.2b	JP¥437.1b
Growth Rate Estimate Source	Analyst x4	Analyst x5	Analyst x5	Analyst x2	Analyst x1	Est @ 9.43%	Est @ 6.71%	Est @ 4.81%	Est @ 3.48%	Est @ 2.55%
Present Value (¥, Millions) Discounted @ 6.9%	JP¥9.4k	JP¥193.5k	JP¥211.0k	JP¥222.9k	JP¥241.0k	JP¥246.8k	JP¥246.3k	JP¥241.5k	JP¥233.8k	JP¥224.3k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = JP¥2.1t

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 6.9%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = JP¥437b× (1 + 0.4%) ÷ (6.9%– 0.4%) = JP¥6.7t

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= JP¥6.7t÷ ( 1 + 6.9%)¹⁰= JP¥3.4t

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¥5.5t. 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¥3.2k, the company appears a touch undervalued at a 22% 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

We would point out that 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 NEC 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 6.9%, which is based on a levered beta of 1.239. 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.

See our latest analysis for NEC

SWOT Analysis for NEC

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Why is the intrinsic value higher than the current share price? For NEC, there are three additional items you should explore:

1. Risks: For example, we've discovered 1 warning sign for NEC that you should be aware of before investing here.
2. Future Earnings: How does 6701'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 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.