Shikoku Electric Power Company, Incorporated's (TSE:9507) Intrinsic Value Is Potentially 27% Above Its Share Price

Key Insights

• Shikoku Electric Power Company's estimated fair value is JP¥1,591 based on 2 Stage Free Cash Flow to Equity
• Current share price of JP¥1,250 suggests Shikoku Electric Power Company is potentially 21% undervalued
• The JP¥1,400 analyst price target for 9507 is 12% less than our estimate of fair value

In this article we are going to estimate the intrinsic value of Shikoku Electric Power Company, Incorporated (TSE:9507) by taking the expected future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Believe it or not, it's not too difficult to follow, as you'll see from our example!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

See our latest analysis for Shikoku Electric Power Company

The Model

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To begin with, we have to get estimates of the next ten years of cash flows. 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 companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (¥, Millions)	JP¥24.0b	JP¥22.5b	JP¥18.4b	JP¥19.4b	JP¥20.4b	JP¥20.0b	JP¥19.7b	JP¥19.6b	JP¥19.5b	JP¥19.5b
Growth Rate Estimate Source	Analyst x1	Analyst x2	Analyst x2	Analyst x2	Analyst x2	Est @ -1.80%	Est @ -1.18%	Est @ -0.75%	Est @ -0.45%	Est @ -0.23%
Present Value (¥, Millions) Discounted @ 6.2%	JP¥22.6k	JP¥19.9k	JP¥15.3k	JP¥15.2k	JP¥15.0k	JP¥13.9k	JP¥12.9k	JP¥12.1k	JP¥11.3k	JP¥10.6k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = JP¥149b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 0.3%. We discount the terminal cash flows to today's value at a cost of equity of 6.2%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = JP¥19b× (1 + 0.3%) ÷ (6.2%– 0.3%) = JP¥326b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= JP¥326b÷ ( 1 + 6.2%)¹⁰= JP¥178b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is JP¥327b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of JP¥1.3k, the company appears a touch undervalued at a 21% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at Shikoku Electric Power Company 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 accounts for debt. In this calculation we've used 6.2%, which is based on a levered beta of 1.201. Beta is a measure of a stock's volatility, compared 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.

SWOT Analysis for Shikoku Electric Power Company

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. What is the reason for the share price sitting below the intrinsic value? For Shikoku Electric Power Company, there are three additional elements you should consider:

1. Risks: As an example, we've found 3 warning signs for Shikoku Electric Power Company (2 shouldn't be ignored!) that you need to consider before investing here.
2. Future Earnings: How does 9507's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
3. Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

PS. The Simply Wall St app conducts 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 article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.