A look at the fair value of Tong Herr Resources Berhad (KLSE:TONGHER)

Key findings

• The forecast fair value for Tong Herr Resources Berhad is RM2.10 based on the 2-step Free Cash Flow to Equity

• The current share price of RM2.30 suggests that Tong Herr Resources Berhad may be trading close to its fair value.

• The industry average of 170% suggests that Tong Herr Resources Berhad’s competitors are currently trading at a higher premium to fair value

In this article, we will estimate the intrinsic value of Tong Herr Resources Berhad (KLSE:TONGHER) by projecting its future cash flows and then discounting them to today’s value. We will do this using the Discounted Cash Flow (DCF) model. Don’t be put off by the jargon, the math behind it is actually quite simple.

However, keep in mind that there are many ways to estimate the value of a company, and a DCF is just one of them. If you want to learn more about intrinsic value, you should check out Simply Wall St’s analysis model.

Check out our latest analysis for Tong Herr Resources Berhad.

The model

We use a two-stage DCF model which, as the name suggests, considers two stages of growth. The first stage is generally a higher growth stage that stabilizes toward the terminal value, which is captured in the second “steady growth” stage. The first stage requires us to estimate the company’s cash flows for the next ten years. Since we don’t have analyst estimates of free cash flow available, we extrapolated the previous free cash flow (FCF) from the company’s last 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 account for the fact that growth tends to slow more in the early years than in later years.

A DCF is all about the idea that a dollar in the future is worth less than a dollar today. So we discount the value of these future cash flows to their estimated value in today’s dollars:

Estimation of free cash flow (FCF) over 10 years

(“Est” = FCF growth rate, estimated by Simply Wall St)
Present value of 10-year cash flow (PVCF) = 175 million RM

The story goes on

The second period is also called the terminal value. This is the company’s cash flow after the first period. For various reasons, a very conservative growth rate is used, which cannot exceed a country’s GDP growth. In this case, we used the 5-year average of the 10-year Treasury yield (3.6%) 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 10%.

Final value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = RM24m × (1 + 3.6%) ÷ (10% – 3.6%) = RM384m

Present value of terminal value (PVTV)= TV / (1 + r)¹⁰= 384 million RM ÷ (1 + 10%)¹⁰= 147 million RM

The total value or equity value is then the sum of the present value of future cash flows, which in this case is RM322 million. The final step is to divide the equity value by the number of shares in issue. Relative to the current share price of RM2.3, the company appears roughly at fair value at the time of writing. However, valuations are imprecise instruments, much like a telescope – move a few degrees and you end up in another galaxy. Keep this in mind.

Important assumptions

The above calculation heavily depends on two assumptions. The first is the discount rate and the other is the cash flows. If you disagree with these results, try the calculation yourself and play with the 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 Tong Herr Resources Berhad as prospective 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 have used 10% which is based on a levered beta of 1.025. Beta is a measure of a stock’s volatility relative to the overall market. 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 Tong Herr Resources Berhad

Strength

weakness

Opportunity

Danger

Next Steps:

Valuation is only one side of the coin in developing your investment thesis and ideally shouldn’t be the only analysis you look at for a company. It’s not possible to get a foolproof valuation using a DCF model. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. If a company grows differently, or its cost of equity or risk-free rate changes significantly, the outcome could be very different. For Tong Herr Resources Berhad, we’ve put together three other elements you should examine in more detail:

1. Risks: For this purpose, you should consult the 3 warning signs we discovered it at Tong Herr Resources Berhad.

2. Other high-quality alternatives: Like a good all-rounder? Explore our interactive list of high-quality stocks to get a sense of what else you might be missing out on!

3. More top analyst tips: Want to know what the analysts think? Take a look at our interactive list of analyst recommended stocks and find out which stocks they think could have attractive future prospects!

PS The Simply Wall St app runs a discounted cash flow valuation for every stock on the KLSE 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 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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