Is Formosa Chemicals & Fibre Corporation (TPE:1326) Worth NT$85.6 Based On Its Intrinsic Value?

Today we will run through one way of estimating the intrinsic value of Formosa Chemicals & Fibre Corporation (TPE:1326) by estimating the company's future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for Formosa Chemicals & Fibre

What's the estimated valuation?

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. 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.

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$23.5b	NT$27.9b	NT$26.9b	NT$26.2b	NT$25.8b	NT$25.7b	NT$25.6b	NT$25.6b	NT$25.7b	NT$25.8b
Growth Rate Estimate Source	Analyst x4	Analyst x4	Est @ -3.74%	Est @ -2.37%	Est @ -1.41%	Est @ -0.74%	Est @ -0.27%	Est @ 0.06%	Est @ 0.29%	Est @ 0.45%
Present Value (NT$, Millions) Discounted @ 7.3%	NT$21.9k	NT$24.2k	NT$21.8k	NT$19.8k	NT$18.2k	NT$16.8k	NT$15.7k	NT$14.6k	NT$13.7k	NT$12.8k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NT$179b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 7.3%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = NT$26b× (1 + 0.8%) ÷ (7.3%– 0.8%) = NT$404b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= NT$404b÷ ( 1 + 7.3%)¹⁰= NT$200b

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$380b. 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$85.6, the company appears reasonably expensive 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.

Important 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. 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 Formosa Chemicals & Fibre 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 7.3%, which is based on a levered beta of 1.051. 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:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. 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. What is the reason for the share price exceeding the intrinsic value? For Formosa Chemicals & Fibre, we've put together three pertinent aspects you should assess:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Formosa Chemicals & Fibre , and understanding these should be part of your investment process.
2. Future Earnings: How does 1326'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 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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