Hup Seng Industries Berhad (KLSE: HUPSENG) shares could exceed their estimate of intrinsic value by 27%
Today we’re going to walk through one way to estimate the intrinsic value of Hup Seng Industries Berhad (KLSE: HUPSENG) by estimating the company’s future cash flows and discounting them to their present value. Our analysis will use the Discounted Cash Flow (DCF) model. It may sound complicated, but it’s actually quite simple!
We would like to point out that there are many ways to assess a business and, like DCF, each technique has advantages and disadvantages in certain scenarios. If you want to know more about discounted cash flow, the rationale for this calculation can be read in detail in the Simply Wall St.
Check out our latest analysis for Hup Seng Industries Berhad
Is Hup Seng Industries Berhad valued enough?
We are going to use a two-step DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “steady growth”. To begin with, we need to get cash flow estimates for the next ten years. Since no analysts estimate of free cash flow is available to us, we have extrapolated past free cash flow (FCF) from the last reported value of the company. We assume that companies with decreasing free cash flow will slow their withdrawal rate, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect that growth tends to slow down more in the early years than in the later years.
Typically, we assume that a dollar today is worth more than a dollar in the future, and so the sum of these future cash flows is then discounted to present value:
10-year free cash flow (FCF) estimate
2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | |
Leverage FCF (MYR, millions) | RM34.4m | RM33.0m | RM32.5m | RM32.4m | RM32.7m | 33.3 m RM | RM34.1m | RM35.0m | RM36.1m | RM37.2m |
Source of estimated growth rate | Is at -7.38% | Is @ -4.08% | Is at -1.77% | East @ -0.15% | Is 0.98% | Is at 1.77% | Is 2.33% | Is 2.71% | Is 2.99% | Is 3.18% |
Present value (MYR, millions) discounted at 8.3% | RM31.8 | RM28.2 | RM25.5 | 23.5 RM | 21.9 RM | RM20.6 | RM19.5 | RM18.5 | 17.6 RM | RM16.7 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flow (PVCF) = RM223m
The second stage is also known as terminal value, it is the cash flow of the business after the first stage. 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 government bond yield of 3.6%. We discount the terminal cash flows to their present value at a cost of equity of 8.3%.
Terminal value (TV)= FCF_{2030} × (1 + g) ÷ (r – g) = RM37m × (1 + 3.6%) ÷ (8.3% – 3.6%) = RM819m
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= RM819m ÷ (1 + 8.3%)^{ten}= RM368m
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which translates to the total value of equity, which in this case is RM 591 million. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of RM 0.9, the company appears to be slightly overvalued at the time of writing. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.
Important assumptions
We draw your attention to the fact that the most important data for a discounted cash flow is the discount rate and, of course, the actual cash flow. You don’t have to agree with these entries, I recommend that you redo the math yourself and play around with it. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view Hup Seng Industries Berhad 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 into account debt. In this calculation, we used 8.3%, which is based on a leverage beta of 0.800. Beta is a measure of the volatility of a stock, relative to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Next steps:
Valuation is only one side of the coin in terms of building your investment thesis, and it’s just one of the many factors you need to evaluate for a business. The DCF model is not a perfect inventory valuation tool. Preferably, you would apply different cases and assumptions and see how they would impact the valuation of the business. If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. What is the reason why the stock price exceeds intrinsic value? For Hup Seng Industries Berhad, there are three fundamental elements to consider:
- Risks: Be aware that Hup Seng Industries Berhad shows 1 warning sign in our investment analysis , you should know …
- Future income: How does HUPSENG’s growth rate compare to its peers and to the market in general? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth forecast chart.
- Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high quality inventory to get a feel for what you might be missing!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for each KLSE share. If you want to find the calculation for other actions, just search here.
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