Is There An Opportunity With LG Innotek Co., Ltd.'s (KRX:011070) 44% Undervaluation?

Does the November share price for LG Innotek Co., Ltd. (KRX:011070) 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 take advantage of the Discounted Cash Flow (DCF) model for this purpose. 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. 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 LG Innotek

The model

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. 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) estimate

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (₩, Millions)	₩434.2b	₩538.6b	₩619.4b	₩691.6b	₩756.0b	₩814.0b	₩867.2b	₩916.9b	₩964.3b	₩1.01t
Growth Rate Estimate Source	Analyst x13	Analyst x12	Est @ 14.99%	Est @ 11.65%	Est @ 9.32%	Est @ 7.68%	Est @ 6.53%	Est @ 5.73%	Est @ 5.17%	Est @ 4.78%
Present Value (₩, Millions) Discounted @ 13%	₩383.1k	₩419.4k	₩425.5k	₩419.2k	₩404.4k	₩384.2k	₩361.1k	₩336.9k	₩312.7k	₩289.1k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ₩3.7t

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 3.9%. We discount the terminal cash flows to today's value at a cost of equity of 13%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = ₩1.0t× (1 + 3.9%) ÷ (13%– 3.9%) = ₩11t

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= ₩11t÷ ( 1 + 13%)¹⁰= ₩3.2t

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 ₩6.9t. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of ₩163k, the company appears quite undervalued at a 44% discount to where the stock price trades currently. 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

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 LG Innotek 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 13%, which is based on a levered beta of 1.369. 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. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For LG Innotek, there are three pertinent aspects you should consider:

1. Risks: Take risks, for example - LG Innotek has 2 warning signs we think you should be aware of.
2. Future Earnings: How does A011070'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 KOSE 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. 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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