A Look At The Fair Value Of L&K Engineering Co., Ltd. (TWSE:6139)

Key Insights

• L&K Engineering's estimated fair value is NT$252 based on 2 Stage Free Cash Flow to Equity
• With NT$281 share price, L&K Engineering appears to be trading close to its estimated fair value
• L&K Engineering's peers seem to be trading at a higher premium to fair value based onthe industry average of -74%

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of L&K Engineering Co., Ltd. (TWSE:6139) 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. Believe it or not, it's not too difficult to follow, as you'll see from our example!

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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for L&K Engineering

Crunching The Numbers

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 begin with, we have to get estimates of the next ten years of cash flows. 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.

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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (NT$, Millions)	NT$4.38b	NT$3.79b	NT$3.44b	NT$3.22b	NT$3.09b	NT$3.01b	NT$2.96b	NT$2.93b	NT$2.92b	NT$2.92b
Growth Rate Estimate Source	Est @ -19.78%	Est @ -13.60%	Est @ -9.27%	Est @ -6.25%	Est @ -4.13%	Est @ -2.64%	Est @ -1.60%	Est @ -0.88%	Est @ -0.37%	Est @ -0.01%
Present Value (NT$, Millions) Discounted @ 5.8%	NT$4.1k	NT$3.4k	NT$2.9k	NT$2.6k	NT$2.3k	NT$2.1k	NT$2.0k	NT$1.9k	NT$1.8k	NT$1.7k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NT$25b

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 (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 5.8%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = NT$2.9b× (1 + 0.8%) ÷ (5.8%– 0.8%) = NT$59b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= NT$59b÷ ( 1 + 5.8%)¹⁰= NT$34b

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$59b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of NT$281, 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 L&K 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 5.8%, which is based on a levered beta of 0.906. 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:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize 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. For L&K Engineering, we've compiled three additional aspects you should assess:

1. Risks: For example, we've discovered 3 warning signs for L&K Engineering (1 makes us a bit uncomfortable!) that you should be aware of before investing here.
2. 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!
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. 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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.