Calculating The Fair Value Of ELAN Microelectronics Corporation (TPE:2458)

Does the April share price for ELAN Microelectronics Corporation (TPE:2458) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by projecting its future cash flows and then discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

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.

See our latest analysis for ELAN Microelectronics

Crunching the numbers

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) forecast

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (NT$, Millions)	NT$4.99b	NT$4.52b	NT$4.25b	NT$4.08b	NT$3.97b	NT$3.91b	NT$3.88b	NT$3.87b	NT$3.87b	NT$3.88b
Growth Rate Estimate Source	Analyst x3	Analyst x2	Est @ -6.08%	Est @ -4%	Est @ -2.55%	Est @ -1.54%	Est @ -0.83%	Est @ -0.33%	Est @ 0.02%	Est @ 0.26%
Present Value (NT$, Millions) Discounted @ 7.7%	NT$4.6k	NT$3.9k	NT$3.4k	NT$3.0k	NT$2.7k	NT$2.5k	NT$2.3k	NT$2.1k	NT$2.0k	NT$1.8k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NT$28b

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. 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 7.7%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = NT$3.9b× (1 + 0.8%) ÷ (7.7%– 0.8%) = NT$57b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= NT$57b÷ ( 1 + 7.7%)¹⁰= NT$27b

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$55b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of NT$195, the company appears around fair value at the time of writing. 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.

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 ELAN Microelectronics 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 7.7%, which is based on a levered beta of 1.126. 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:

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. The DCF model is not a perfect stock valuation tool. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For ELAN Microelectronics, we've put together three fundamental items you should further examine:

1. Risks: We feel that you should assess the 2 warning signs for ELAN Microelectronics we've flagged before making an investment in the company.
2. Future Earnings: How does 2458'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. 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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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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