Today we will run through one way of estimating the intrinsic value of Wowprime Corp. (TPE:2727) by taking the expected future cash flows and discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Believe it or not, it's not too difficult to follow, as you'll see from our example!
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
Check out our latest analysis for Wowprime
The calculation
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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.
Generally we assume that a dollar today is more valuable than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) estimate
2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | |
Levered FCF (NT$, Millions) | NT$1.48b | NT$1.67b | NT$1.82b | NT$1.94b | NT$2.03b | NT$2.10b | NT$2.16b | NT$2.21b | NT$2.25b | NT$2.28b |
Growth Rate Estimate Source | Est @ 17.49% | Est @ 12.5% | Est @ 9% | Est @ 6.55% | Est @ 4.83% | Est @ 3.63% | Est @ 2.79% | Est @ 2.2% | Est @ 1.79% | Est @ 1.5% |
Present Value (NT$, Millions) Discounted @ 9.4% | NT$1.4k | NT$1.4k | NT$1.4k | NT$1.4k | NT$1.3k | NT$1.2k | NT$1.2k | NT$1.1k | NT$1.0k | NT$929 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NT$12b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 0.8%. We discount the terminal cash flows to today's value at a cost of equity of 9.4%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = NT$2.3b× (1 + 0.8%) ÷ (9.4%– 0.8%) = NT$27b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= NT$27b÷ ( 1 + 9.4%)10= NT$11b
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 NT$23b. 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$158, the company appears quite undervalued at a 48% 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.
The assumptions
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Wowprime 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 9.4%, which is based on a levered beta of 1.400. 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:
Whilst important, the DCF calculation is only one of many factors that you need to assess 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 Wowprime, we've put together three further items you should consider:
- Risks: For example, we've discovered 3 warning signs for Wowprime that you should be aware of before investing here.
- Future Earnings: How does 2727'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.
- 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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the TSEC every day. If you want to find the calculation for other stocks just search here.
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About TWSE:2727
Wowprime
Operates restaurants and coffee/tea shops in Taiwan and Mainland China.
Undervalued with excellent balance sheet and pays a dividend.