A look at the fair value of IHI Corporation (TSE:7013)

Key findings

• The estimated fair value of IHI is JP¥4,242 based on the 2-step free cash flow to equity
• The current share price of JP¥4,477 suggests that IHI may be trading close to its fair value.
• The analyst price target of JP¥4,150 for 7013 is 2.2% below our fair value estimate

How far is IHI Corporation (TSE:7013) from its intrinsic value? Using the most recent financial data, we will check if the stock is fairly valued by estimating the company’s future cash flows and discounting them to their current value. We do this using the Discounted Cash Flow (DCF) model. Models like these may seem incomprehensible to a layperson, but they are relatively easy to follow.

Companies can be valued in many ways, so we would like to point out that a DCF is not perfect for every situation. For those who enjoy stock analysis, the analysis model from Simply Wall St listed here might be of interest.

Check out our latest analysis for IHI

The calculation

We use the 2-stage growth model, which simply means that we consider two stages of company 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 down 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, 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) = 226 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 8.1%.

Final value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = 71b JP¥ × (1 + 0.2%) ÷ (8.1% – 0.2%) = 904b JP¥

Present value of terminal value (PVTV)= TV / (1 + r)¹⁰= 904 billion JPY ÷ ( 1 + 8.1 %)¹⁰= 416 billion 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¥642 billion. In the final step, we divide the equity value by the number of shares outstanding. Relative to the current share price of JP¥4.5k, the company is roughly at fair value at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it’s better to consider this a rough estimate that isn’t 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. Part of investing is making your own assessment of a company’s future performance, so try the calculation yourself and check your own assumptions. The 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 IHI 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 8.1%, which is based on a leveraged beta of 1.399. 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 a set limit between 0.8 and 2.0, which is a reasonable range for a stable company.

SWOT analysis for IHI

Next Steps:

Valuation is only one side of the coin when building your investment thesis and should not be the only metric you consider when researching a company. DCF models are not the be-all and end-all of investment valuation. Rather, they should be viewed as a guide to “what assumptions need to hold for this stock to be under/overvalued.” For example, changes in the company’s cost of equity or risk-free interest rate can significantly affect valuation. For IHI, there are three relevant aspects you should consider:

1. Risks: For example, we found 3 warning signs for IHI (2 should not be ignored) You should be aware of this.
2. Future income: How does 7013’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 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!

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 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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