Keisei Electric Railway Co., Ltd. (TSE:9009) shares could be 22% below their estimated intrinsic value

Key findings

• The estimated fair value of Keisei Electric Railway is JP¥6,550 based on the 2-step free cash flow to equity
• Keisei Electric Railway is estimated to be undervalued by 22% based on the current share price of JPY 5,106.
• The analyst price target of JP¥5,638 for 9009 is 14% below our fair value estimate

How far is Keisei Electric Railway Co., Ltd. (TSE:9009) from its intrinsic value? Using the most recent financial data, we will check if the stock is fairly valued by projecting its future cash flows and then discounting those to today’s value. One way to do this is by applying the Discounted Cash Flow (DCF) model. Believe it or not, it’s not too difficult to follow, as you’ll see from our example!

We generally believe that the value of a company is the present value of all the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without its flaws. If you want to learn more about discounted cash flow, you can read the reasoning behind this calculation in detail in Simply Wall St’s analysis model.

Check out our latest analysis for Keisei Electric Railway.

The model

We use a two-stage DCF model which, as the name suggests, considers two phases of growth. The first stage is generally a higher growth phase that stabilizes toward the terminal value captured in the second “steady growth” stage. First, we need to obtain estimates of 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 that companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will slow their growth rate over this period. We do this to take into account that growth tends to slow more in the early years than in later years.

A DCF is based on the idea that a dollar in the future is worth less than a dollar today. Therefore, the sum of these future cash flows is discounted to today’s value:

10-year free cash flow (FCF) forecast

(“Est” = FCF growth rate, estimated by Simply Wall St)
Present value of 10-year cash flow (PVCF) = 334 billion JPY

After calculating the present value of future cash flows in the first 10-year period, we need to calculate the terminal value that takes into account all future cash flows after the first period. The Gordon growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year Treasury yield of 0.2%. We discount the terminal cash flows to today’s value at a cost of equity of 6.8%.

Final value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = 93 JP¥ × (1 + 0.2%) ÷ (6.8% – 0.2%) = 1.4 JP¥

Present value of terminal value (PVTV)= TV / (1 + r)¹⁰= 1.4 t JP¥ ÷ (1 + 6.8 %)¹⁰= 730 billion JPY

Total value is the sum of the next ten years’ cash flows plus the discounted terminal value, which gives the total value of equity, which in this case is JP¥1.1 trillion. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of JP¥5.1k, the company appears somewhat undervalued at a 22% discount to the current share price. However, keep in mind that this is only an approximate valuation and as with any complex formula, where there’s garbage in, there’s garbage out.

The assumptions

The above calculation relies heavily on two assumptions. The first is the discount rate and the other is cash flows. Part of investing is making your own assessment of a company’s future performance, so try the calculation yourself and check your own assumptions. DCF also does not take into account the possible cyclicality of an industry or a company’s future capital needs and therefore does not provide a complete picture of a company’s potential performance. Since we are considering Keisei Electric Railway 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 takes debt into account. In this calculation, we used 6.8%, which is based on a leveraged beta of 1.169. Beta is a measure of a stock’s volatility relative to the market as a whole. We get our beta from the industry average beta of globally comparable companies with an imposed limit of between 0.8 and 2.0, which is a reasonable range for a stable company.

SWOT Analysis for Keisei Electric Railway

Looking ahead:

Although the DCF calculation is important, ideally it should not be the only analysis you look at for a company. The DCF model is not a perfect tool for stock valuation. You should rather apply different cases and assumptions and see how they affect the valuation of the company. For example, if the growth rate of the terminal value is adjusted slightly, it can change the overall result dramatically. Why is the intrinsic value higher than the current share price? For Keisei Electric Railway, we have compiled three relevant factors that you should examine in more detail:

1. Risks: Note that Keisei Electric Railway shows 3 warning signals in our investment analysis and 2 of them are worrying…
2. Future income: How does 9009’s growth rate compare to competitors and the overall market? Learn more about analyst consensus numbers for the coming years by using our free chart of analyst growth expectations.
3. Other solid companies: Low debt, high returns on equity, and good past performance are the foundation of a strong company. Check out our interactive list of stocks with solid business fundamentals to see if there are any other companies you may not have considered!

PS. The Simply Wall St app runs a discounted cash flow valuation for every stock on the TSE every day. If you want to find the calculation for other stocks, just search here.

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This Simply Wall St article is of a general nature. We comment solely on the basis of historical data and analyst forecasts, using an unbiased methodology. Our articles do not constitute financial advice. It is not a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. Our goal is to provide you with long-term analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative materials. Simply Wall St does not hold any of the stocks mentioned.

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