Is IHI Corporation (TSE:7013) Expensive For A Reason? A Look At Its Intrinsic Value

Key Insights

• The projected fair value for IHI is JP¥2,244 based on 2 Stage Free Cash Flow to Equity
• IHI's JP¥2,755 share price signals that it might be 23% overvalued
• Our fair value estimate is 30% lower than IHI's analyst price target of JP¥3,210

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of IHI Corporation (TSE:7013) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

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.

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Step By Step Through The Calculation

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

	2026	2027	2028	2029	2030	2031	2032	2033	2034	2035
Levered FCF (¥, Millions)	JP¥32.4b	JP¥75.6b	JP¥90.2b	JP¥126.8b	JP¥143.5b	JP¥155.2b	JP¥164.3b	JP¥171.4b	JP¥176.9b	JP¥181.2b
Growth Rate Estimate Source	Analyst x7	Analyst x7	Analyst x7	Analyst x2	Analyst x2	Est @ 8.16%	Est @ 5.89%	Est @ 4.30%	Est @ 3.19%	Est @ 2.41%
Present Value (¥, Millions) Discounted @ 6.8%	JP¥30.3k	JP¥66.2k	JP¥74.0k	JP¥97.3k	JP¥103.1k	JP¥104.4k	JP¥103.4k	JP¥101.0k	JP¥97.5k	JP¥93.5k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = JP¥871b

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 0.6%. We discount the terminal cash flows to today's value at a cost of equity of 6.8%.

Terminal Value (TV)= FCF₂₀₃₅ × (1 + g) ÷ (r – g) = JP¥181b× (1 + 0.6%) ÷ (6.8%– 0.6%) = JP¥2.9t

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= JP¥2.9t÷ ( 1 + 6.8%)¹⁰= JP¥1.5t

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¥2.4t. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of JP¥2.8k, the company appears slightly overvalued 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.

The Assumptions

We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual 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 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 accounts for debt. In this calculation we've used 6.8%, which is based on a levered beta of 1.188. 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.

View our latest analysis for IHI

SWOT Analysis for IHI

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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. Can we work out why the company is trading at a premium to intrinsic value? For IHI, there are three pertinent items you should further research:

1. Risks: Be aware that IHI is showing 2 warning signs in our investment analysis , you should know about...
2. Future Earnings: How does 7013'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 High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.