A look at the fair value of Mitsubishi Heavy Industries, Ltd. (TSE:7011)

Key findings

• Using the 2-step free cash flow to equity, the fair value of Mitsubishi Heavy Industries is JP¥2,052.
• Mitsubishi Heavy Industries’ share price of JP¥1,844 suggests that the stock price is at a similar level to the estimated fair value.
• The analyst price target of 1,673 JP¥ for 7011 is 18% below our fair value estimate

In this article, we will estimate the intrinsic value of Mitsubishi Heavy Industries, Ltd. (TSE:7011) by taking the expected future cash flows and discounting them to today’s value. We will use the Discounted Cash Flow (DCF) model on this occasion. There is actually not too much involved in it, even though it may seem quite complex.

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 it is not without its flaws. If you still have some burning questions about this type of valuation, take a look at Simply Wall St’s analysis model.

Check out our latest analysis for Mitsubishi Heavy Industries

What is the estimated value?

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 get estimates of the next ten years of 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. 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) = 2.6 tons 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 6.3%.

Final value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = 484b JP¥ × (1 + 0.2%) ÷ (6.3% – 0.2%) = 8.0 JP¥

Present value of terminal value (PVTV)= TV / (1 + r)¹⁰= 8.0 t JPY ÷ (1 + 6.3 %)¹⁰= 4.3 tons 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¥6.9 trillion. The final step is to divide the equity value by the number of shares outstanding. Compared to the current share price of JP¥1.8k, the company appears to be about fair value, at a 10% discount to the current share price. However, valuations are imprecise instruments, much like a telescope – move a few degrees and you end up in another galaxy. Keep that in mind.

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. 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 are considering Mitsubishi Heavy Industries 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 used 6.3%, which is based on a levered beta of 1.079. 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 Mitsubishi Heavy Industries

Looking ahead:

While important, the DCF calculation is just one of many factors you need to evaluate 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.” If a company grows differently, or its cost of equity or risk-free rate changes significantly, the outcome can look very different. For Mitsubishi Heavy Industries, we’ve put together three more points you should examine:

1. Risks: For example, we found 1 warning sign for Mitsubishi Heavy Industries that you should know before investing here.
2. Future income: How does 7011’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 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 the basis of 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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