Calculating The Intrinsic Value Of Kenmec Mechanical Engineering Co., Ltd. (GTSM:6125)

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Kenmec Mechanical Engineering Co., Ltd. (GTSM:6125) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. This will be done using 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.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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 Kenmec Mechanical Engineering

Is Kenmec Mechanical Engineering fairly valued?

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. In the first stage we need to estimate the cash flows to the business over the next ten years. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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, 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$300.2m	NT$333.1m	NT$359.5m	NT$380.3m	NT$396.7m	NT$409.7m	NT$420.1m	NT$428.6m	NT$435.7m	NT$441.9m
Growth Rate Estimate Source	Est @ 15.32%	Est @ 10.97%	Est @ 7.93%	Est @ 5.8%	Est @ 4.31%	Est @ 3.26%	Est @ 2.53%	Est @ 2.02%	Est @ 1.67%	Est @ 1.41%
Present Value (NT$, Millions) Discounted @ 8.3%	NT$277	NT$284	NT$283	NT$276	NT$266	NT$254	NT$240	NT$226	NT$212	NT$199

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NT$2.5b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 8.3%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = NT$442m× (1 + 0.8%) ÷ (8.3%– 0.8%) = NT$6.0b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= NT$6.0b÷ ( 1 + 8.3%)¹⁰= NT$2.7b

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$5.2b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of NT$23.6, the company appears around fair value at the time of writing. 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.

The 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. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Kenmec Mechanical Engineering 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 8.3%, which is based on a levered beta of 1.223. 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:

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. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Kenmec Mechanical Engineering, there are three essential aspects you should assess:

1. Risks: To that end, you should be aware of the 4 warning signs we've spotted with Kenmec Mechanical Engineering .
2. 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!
3. Other Top Analyst Picks: Interested to see what the analysts are thinking? Take a look at our interactive list of analysts' top stock picks to find out what they feel might have an attractive future outlook!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the GTSM 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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