Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Gromutual Berhad (KLSE:GMUTUAL) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Believe it or not, it's not too difficult to follow, as you'll see from our example!
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis 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. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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
2023
2024
2025
2026
2027
2028
2029
2030
2031
2032
Levered FCF (MYR, Millions)
RM12.3m
RM12.1m
RM12.2m
RM12.3m
RM12.6m
RM12.9m
RM13.2m
RM13.6m
RM14.1m
RM14.5m
Growth Rate Estimate Source
Est @ -3.19%
Est @ -1.16%
Est @ 0.26%
Est @ 1.25%
Est @ 1.95%
Est @ 2.43%
Est @ 2.77%
Est @ 3.01%
Est @ 3.18%
Est @ 3.30%
Present Value (MYR, Millions) Discounted @ 15%
RM10.7
RM9.2
RM8.0
RM7.0
RM6.2
RM5.5
RM4.9
RM4.4
RM4.0
RM3.6
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = RM64m
The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 3.6%. We discount the terminal cash flows to today's value at a cost of equity of 15%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= RM131m÷ ( 1 + 15%)10= RM32m
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is RM96m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of RM0.3, the company appears around fair value at the time of writing. 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.
KLSE:GMUTUAL Discounted Cash Flow June 4th 2023
Important Assumptions
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Gromutual 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 accounts for debt. In this calculation we've used 15%, which is based on a levered beta of 1.437. 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 Gromutual Berhad
Strength
Earnings growth over the past year exceeded the industry.
Debt is well covered by earnings.
Weakness
Current share price is above our estimate of fair value.
Opportunity
GMUTUAL's financial characteristics indicate limited near-term opportunities for shareholders.
Lack of analyst coverage makes it difficult to determine GMUTUAL's earnings prospects.
Threat
Debt is not well covered by operating cash flow.
Next Steps:
Although the valuation of a company is important, it shouldn't be the only metric you look at when researching 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. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Gromutual Berhad, there are three essential elements you should further examine:
Risks: Take risks, for example - Gromutual Berhad has 1 warning sign we think you should be aware of.
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 KLSE 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.
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