Are investors undervaluing DENSO Corporation (TSE:6902) by 38%?

Key findings

• The estimated fair value of DENSO is JP¥3,884 based on the 2-step free cash flow to equity
• DENSO is estimated to be 38% undervalued based on the current share price of JPY 2,425.
• The analyst price target of JP¥3,103 for 6902 is 20% below our fair value estimate

How far is DENSO Corporation (TSE:6902) from its intrinsic value? Using the most recent financial data, we will check whether the stock is fairly valued by projecting its future cash flows and then discounting them to today’s value. To do this, we will use the Discounted Cash Flow (DCF) model. Don’t be put off by the technical jargon, the math behind it is actually quite simple.

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 DENSO

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 period of higher growth that stabilizes towards the terminal value, which is captured in the second stage of “steady growth”. The first stage requires us to estimate the company’s cash flows for the next ten years. 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.

In general, we assume that a dollar today is worth more than a dollar in the future. Therefore, the sum of these future cash flows is discounted to today’s 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) = 4.8 tons 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 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 7.0%.

Final value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = 858b JP¥ × (1 + 0.2%) ÷ (7.0% – 0.2%) = 13t JP¥

Present value of terminal value (PVTV)= TV / (1 + r)¹⁰= 13t JP¥ ÷ (1 + 7.0%)¹⁰= 6.5 tons 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¥11 trillion. The final step is to divide the equity value by the number of shares outstanding. Compared to the current share price of JP¥2.4k, the company seems to offer quite good value for money at a 38% discount to the current share price. The assumptions in any calculation have a big impact on the valuation, so it’s better to consider this as a rough estimate that is not accurate to the last cent.

Important assumptions

The key inputs to a discounted cash flow are the discount rate and of course the actual cash flows. You don’t have to agree with these inputs, I recommend repeating the calculations yourself and experimenting with them. The 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 DENSO 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 7.0%, which is based on a leveraged beta of 1.199. 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 DENSO

Looking ahead:

Valuation is only one side of the coin when building your investment thesis and ideally should not be the only analysis you look at for a company. The DCF model is not a perfect stock valuation tool. It should be viewed more as a guide to “what assumptions need to hold for this stock to be under/overvalued”. 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. What is the reason for the stock price being below intrinsic value? For DENSO, there are three relevant aspects you should investigate further:

1. Financial health: Does 6902 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 6902’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 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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