Does the February share price for D-Link Corporation (TPE:2332) 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. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
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. 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, 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) forecast
|Levered FCF (NT$, Millions)||NT$776.8m||NT$834.4m||NT$879.8m||NT$915.5m||NT$943.8m||NT$966.6m||NT$985.3m||NT$1.00b||NT$1.01b||NT$1.03b|
|Growth Rate Estimate Source||Est @ 10.24%||Est @ 7.42%||Est @ 5.44%||Est @ 4.06%||Est @ 3.09%||Est @ 2.41%||Est @ 1.94%||Est @ 1.61%||Est @ 1.37%||Est @ 1.21%|
|Present Value (NT$, Millions) Discounted @ 6.5%||NT$729||NT$736||NT$728||NT$712||NT$689||NT$662||NT$634||NT$605||NT$576||NT$547|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NT$6.6b
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 6.5%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = NT$1.0b× (1 + 0.8%) ÷ (6.5%– 0.8%) = NT$18b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= NT$18b÷ ( 1 + 6.5%)10= NT$9.7b
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$16b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of NT$23.9, the company appears about fair value at a 4.8% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
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 D-Link 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 6.5%, which is based on a levered beta of 0.927. 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.
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. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For D-Link, we've compiled three essential factors you should assess:
- Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with D-Link , and understanding this should be part of your investment process.
- 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!
- Other Environmentally-Friendly Companies: Concerned about the environment and think consumers will buy eco-friendly products more and more? Browse through our interactive list of companies that are thinking about a greener future to discover some stocks you may not have thought of!
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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D-Link Corporation researches, develops, and sells local area computer network systems, wireless local area computer networks, and spare parts for integrated circuits in Taiwan and internationally.
Excellent balance sheet with questionable track record.
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