Calculating The Intrinsic Value Of Hotron Precision Electronic Industrial Co.,Ltd. (GTSM:3092)

Today we will run through one way of estimating the intrinsic value of Hotron Precision Electronic Industrial Co.,Ltd. (GTSM:3092) by estimating the company's future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

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. 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 Hotron Precision Electronic IndustrialLtd

The method

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.

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

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (NT$, Millions)	NT$356.0m	NT$340.8m	NT$331.5m	NT$326.0m	NT$323.0m	NT$321.7m	NT$321.7m	NT$322.4m	NT$323.7m	NT$325.5m
Growth Rate Estimate Source	Analyst x1	Est @ -4.26%	Est @ -2.73%	Est @ -1.66%	Est @ -0.92%	Est @ -0.39%	Est @ -0.03%	Est @ 0.23%	Est @ 0.41%	Est @ 0.54%
Present Value (NT$, Millions) Discounted @ 9.3%	NT$326	NT$286	NT$254	NT$229	NT$208	NT$189	NT$173	NT$159	NT$146	NT$134

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NT$2.1b

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 (0.8%) 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 9.3%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = NT$325m× (1 + 0.8%) ÷ (9.3%– 0.8%) = NT$3.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= NT$3.9b÷ ( 1 + 9.3%)¹⁰= NT$1.6b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is NT$3.7b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of NT$53.9, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

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 Hotron Precision Electronic IndustrialLtd 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 9.3%, which is based on a levered beta of 1.376. 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.

Moving On:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching 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 example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Hotron Precision Electronic IndustrialLtd, we've put together three relevant elements you should assess:

1. Risks: Be aware that Hotron Precision Electronic IndustrialLtd is showing 3 warning signs in our investment analysis , you should know about...
2. Future Earnings: How does 3092'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. Simply Wall St updates its DCF calculation for every Taiwanese 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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