Fair value estimate of Kawaguchi Chemical Industry Co., Ltd (TSE:4361)

Key findings

• The forecast fair value for Kawaguchi Chemical Industry is JP¥1,609 based on the 2-step Free Cash Flow to Equity
• The current share price of JP¥1,619 suggests that Kawaguchi Chemical Industry may be trading close to its fair value.
• The industry average of 8.3% suggests that Kawaguchi Chemical Industry’s competitors are currently trading at a higher premium to fair value

How far is Kawaguchi Chemical Industry Co., Ltd (TSE:4361) from its intrinsic value? Using the most recent financial data, we will check if the stock is fairly valued by taking the expected future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Before you think you can’t understand it, just keep reading! It’s actually a lot less complex than you think.

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 is not without its flaws. For those who enjoy stock analysis, the Simply Wall St analysis model presented here might be of interest.

Check out our latest analysis for Kawaguchi Chemical Industry.

The model

We use what is called a 2-stage model, which simply means that we have two different growth periods for the company’s cash flows. Generally, the first stage is higher growth and the second stage is a period of lower growth. First, we need to get estimates for the next ten years of cash flows. Since we don’t have analyst estimates for free cash flow, 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 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) = 1.1 billion JPY

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 bond yield (0.2%) 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 9.6%.

Final value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = 187 m¥ × (1 + 0.2%) ÷ (9.6% – 0.2%) = 2.0 b¥

Present value of terminal value (PVTV)= TV / (1 + r)¹⁰= JP¥2.0 billion ÷ (1 + 9.6%)¹⁰= 803 million JPY

The total value or equity value is then the sum of the present value of future cash flows, which in this case is JP¥1.9 billion. In the final step, we divide the equity value by the number of shares outstanding. Compared to the current share price of JP¥1.6k, the company appears to be about its 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 consider Kawaguchi Chemical Industry 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 9.6% which is based on a levered beta of 1.662. 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 the chemical industry in Kawaguchi

Go on:

While important, ideally the DCF calculation should not be the only analysis you consider for a company. DCF models are not the be-all and end-all of investment valuation. 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 at a different rate, or if its cost of equity or risk-free rate changes significantly, the outcome may look very different. For Kawaguchi Chemical Industry, there are three relevant factors you should consider:

1. Risks: Take risks, for example – Kawaguchi Chemical Industry has 3 warning signs (and 1 that is potentially serious) that we think you should know about.
2. 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!
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 TSE every day. If you want to find the calculation for other stocks, just search here.

Do you have feedback on this article? Are you concerned about the content? Get in touch directly from us. Alternatively, send an email to editorial-team (at) simplywallst.com.

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.

Do you have feedback on this article? Are you interested in the content? Contact us directly. Alternatively, send an email to [email protected]