Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Hyundai Construction Equipment Co., Ltd. (KRX:267270) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. 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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
What's the estimated valuation?
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.
Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
|Levered FCF (₩, Millions)||₩85.8b||₩130.8b||₩125.4b||₩123.3b||₩123.1b||₩124.4b||₩126.7b||₩129.7b||₩133.3b||₩137.3b|
|Growth Rate Estimate Source||Analyst x4||Analyst x4||Est @ -4.06%||Est @ -1.74%||Est @ -0.11%||Est @ 1.03%||Est @ 1.82%||Est @ 2.38%||Est @ 2.77%||Est @ 3.04%|
|Present Value (₩, Millions) Discounted @ 16%||₩74.2k||₩98.0k||₩81.4k||₩69.3k||₩59.9k||₩52.4k||₩46.2k||₩40.9k||₩36.4k||₩32.5k|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ₩591b
After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 (3.7%) 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 16%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = ₩137b× (1 + 3.7%) ÷ (16%– 3.7%) = ₩1.2t
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= ₩1.2t÷ ( 1 + 16%)10= ₩285b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is ₩876b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of ₩34k, the company appears a touch undervalued at a 25% 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.
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Hyundai Construction Equipment 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 16%, which is based on a levered beta of 1.984. 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.
Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. Why is the intrinsic value higher than the current share price? For Hyundai Construction Equipment, we've compiled three further factors you should consider:
- Risks: You should be aware of the 3 warning signs for Hyundai Construction Equipment (1 is potentially serious!) we've uncovered before considering an investment in the company.
- Future Earnings: How does A267270'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.
- 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. Simply Wall St updates its DCF calculation for every South Korean 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. 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.
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