Estimating The Fair Value Of Kao Corporation (TSE:4452)

Simply Wall St · 11/26 03:58

Key Insights

  • The projected fair value for Kao is JP¥5,971 based on 2 Stage Free Cash Flow to Equity
  • With JP¥6,302 share price, Kao appears to be trading close to its estimated fair value
  • Analyst price target for 4452 is JP¥7,220, which is 21% above our fair value estimate

Today we will run through one way of estimating the intrinsic value of Kao Corporation (TSE:4452) by estimating the company's future cash flows and discounting them to their present value. Our analysis will employ the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for Kao

Step By Step Through The Calculation

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. In the first stage we need to estimate the cash flows to the business over 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 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

2025 2026 2027 2028 2029 2030 2031 2032 2033 2034
Levered FCF (¥, Millions) JP¥113.1b JP¥124.4b JP¥126.7b JP¥134.5b JP¥139.6b JP¥143.5b JP¥146.4b JP¥148.6b JP¥150.3b JP¥151.7b
Growth Rate Estimate Source Analyst x6 Analyst x6 Analyst x3 Analyst x2 Est @ 3.83% Est @ 2.77% Est @ 2.03% Est @ 1.52% Est @ 1.15% Est @ 0.90%
Present Value (¥, Millions) Discounted @ 5.4% JP¥107.2k JP¥111.9k JP¥108.1k JP¥108.8k JP¥107.1k JP¥104.4k JP¥101.0k JP¥97.3k JP¥93.3k JP¥89.3k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = JP¥1.0t

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (0.3%) 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 5.4%.

Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = JP¥152b× (1 + 0.3%) ÷ (5.4%– 0.3%) = JP¥3.0t

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= JP¥3.0t÷ ( 1 + 5.4%)10= JP¥1.7t

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¥2.8t. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of JP¥6.3k, the company appears around fair value at the time of writing. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

dcf
TSE:4452 Discounted Cash Flow November 26th 2024

Important 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 Kao 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 5.4%, which is based on a levered beta of 1.031. 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 Kao

Strength
  • Earnings growth over the past year exceeded the industry.
  • Debt is not viewed as a risk.
  • Dividends are covered by earnings and cash flows.
Weakness
  • Dividend is low compared to the top 25% of dividend payers in the Personal Products market.
Opportunity
  • Annual earnings are forecast to grow faster than the Japanese market.
  • Good value based on P/E ratio compared to estimated Fair P/E ratio.
Threat
  • Annual revenue is forecast to grow slower than the Japanese market.

Moving On:

Whilst important, the DCF calculation 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. Rather it should be seen as a guide to "what assumptions need to be true 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 sharply, the output can look very different. For Kao, we've put together three essential factors you should further examine:

  1. Financial Health: Does 4452 have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
  2. Future Earnings: How does 4452'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. Simply Wall St updates its DCF calculation for every Japanese stock every day, so if you want to find the intrinsic value of any other stock just search here.