Are Investors Undervaluing Kuala Lumpur Kepong Berhad (KLSE:KLK) By 26%?

By
Simply Wall St
Published
December 03, 2021
KLSE:KLK
Source: Shutterstock

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Kuala Lumpur Kepong Berhad (KLSE:KLK) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. Our analysis will employ the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

Check out our latest analysis for Kuala Lumpur Kepong Berhad

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. To start off with, we need to estimate 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

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Levered FCF (MYR, Millions) RM1.05b RM1.21b RM1.32b RM1.41b RM1.49b RM1.56b RM1.64b RM1.71b RM1.78b RM1.85b
Growth Rate Estimate Source Analyst x4 Analyst x5 Analyst x2 Est @ 6.54% Est @ 5.66% Est @ 5.04% Est @ 4.6% Est @ 4.3% Est @ 4.09% Est @ 3.94%
Present Value (MYR, Millions) Discounted @ 7.9% RM973 RM1.0k RM1.1k RM1.0k RM1.0k RM989 RM958 RM926 RM893 RM860

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = RM9.7b

The second stage is also known as Terminal Value, this is the business's cash flow after 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 (3.6%) 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 7.9%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = RM1.8b× (1 + 3.6%) ÷ (7.9%– 3.6%) = RM44b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= RM44b÷ ( 1 + 7.9%)10= RM20b

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 RM30b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of RM20.8, the company appears a touch undervalued at a 26% 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.

dcf
KLSE:KLK Discounted Cash Flow December 4th 2021

Important assumptions

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 Kuala Lumpur Kepong Berhad 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 7.9%, which is based on a levered beta of 0.807. 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.

Looking Ahead:

Whilst important, the DCF calculation 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?" 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. What is the reason for the share price sitting below the intrinsic value? For Kuala Lumpur Kepong Berhad, we've put together three additional items you should further examine:

  1. Risks: To that end, you should learn about the 2 warning signs we've spotted with Kuala Lumpur Kepong Berhad (including 1 which can't be ignored) .
  2. Future Earnings: How does KLK'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. Simply Wall St updates its DCF calculation for every Malaysian stock every day, so if you want to find the intrinsic value of any other stock just search here.

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