A look at the intrinsic value of Otsuka Corporation (TSE:4768)

Key findings

• The estimated fair value of Otsuka is JP¥3,260 based on the 2-step free cash flow to equity
• The current share price of JP¥2,900 suggests that Otsuka may be trading close to its fair value
• The analyst price target of 3,510 JP¥ for 4768 is 7.7% above our fair value estimate

Today we’ll walk through a method to estimate the intrinsic value of Otsuka Corporation (TSE:4768) by projecting its future cash flows and then discounting them to today’s value. This is done using the discounted cash flow (DCF) model. Before you think you can’t understand it, just keep reading! It’s actually a lot less complex than you think.

We would like to point out that there are many ways to value a company and that each method, like DCF, has advantages and disadvantages in certain scenarios. If you want to learn more about discounted cash flow, you can read the basics of this calculation in detail in Simply Wall St’s analysis model.

Check out our latest analysis for Otsuka

Step by step through the calculation

We use the two-stage growth model, which simply means that we consider two stages of the company’s growth. In the early stage, the company might have a higher growth rate, and in the second stage, a stable growth rate is usually assumed. First, we need to estimate the next ten years’ cash flows. Where possible, we use analyst estimates, but when these are not 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 all about the idea that a dollar in the future is worth less than a dollar today. Therefore, we need to discount the sum of these future cash flows to arrive at an estimate of present value:

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) = 490 billion JPY

We now need to calculate the terminal value that takes into account all future cash flows after this ten-year 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 6.2%.

Final value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = 82b JP¥ × (1 + 0.2%) ÷ (6.2% – 0.2%) = 1.4 JP¥

Present value of terminal value (PVTV)= TV / (1 + r)¹⁰= 1.4t JPY ÷ (1 + 6.2%)¹⁰= 746 billion JPY

The total value is the sum of the next ten years’ cash flows plus the discounted terminal value, which gives the total equity value, which in this case is JP¥1.2 trillion. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of JP¥2.9k, the company seems to be about fair value at an 11% 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.

Important assumptions

The key inputs to a discounted cash flow are the discount rate and of course the actual 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 potential 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 view Otsuka 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 6.2%, which is based on a levered beta of 1.066. 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 a set limit between 0.8 and 2.0, which is a reasonable range for a stable company.

SWOT analysis for Otsuka

Next Steps:

Valuation is only one side of the coin when building your investment thesis and just one of many factors you need to evaluate for a company. It is 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 an undervaluation or overvaluation of the company. If a company grows differently or its cost of equity or risk-free rate changes significantly, the outcome can be very different. For Otsuka, we have put together three basic points for you to explore further:

1. Financial health: Does 4768 have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks for key factors such as debt and risk.
2. Future income: How does 4768’s growth rate compare to its 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. Simply Wall St updates its DCF calculation for each Japanese stock daily, so if you want to find out the intrinsic value of another stock, just search here.

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This Simply Wall St article is of a general nature. We comment based 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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