Calculation of the fair value of PETRONAS Chemicals Group Berhad (KLSE: PCHEM)
Today we are going to review a valuation method used to estimate the attractiveness of PETRONAS Chemicals Group Berhad (KLSE: PCHEM) as an investment opportunity by taking expected future cash flows and discounting them. at their current value. To this end, we will take advantage of the Discounted Cash Flow (DCF) model. Don’t be put off by the lingo, the math is actually pretty straightforward.
There are many ways businesses can be assessed, so we would like to point out that a DCF is not perfect for all situations. For those who are passionate about equity analysis, the Simply Wall St analysis template here may be something of interest to you.
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Crunch the numbers
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”. In the first step, we need to estimate the cash flow of the business over the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated value. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we discount the value of those future cash flows to their estimated value in today’s dollars. hui:
10-year free cash flow (FCF) forecast
|Leverage FCF (MYR, Millions)||RM3.30b||RM3.71b||RM4.03b||RM4.32b||RM4.59b||RM4.83b||RM5.07b||RM5.29b||RM5.51b||RM5.74b|
|Source of estimated growth rate||Analyst x6||Analyst x5||Est @ 8.66%||Est @ 7.15%||Is 6.09%||East @ 5.35%||Est @ 4.83%||East @ 4.47%||Is 4.21%||Is 4.04%|
|Present value (MYR, millions) discounted at 9.4%||RM3.0k||RM3.1k||RM3.1k||RM3.0k||RM2.9k||RM2.8k||RM2.7k||RM2.6k||RM2.5k||RM2.3k|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = RM28b
The second stage is also known as terminal value, this 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 9.4%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = RM5.7b × (1 + 3.6%) ÷ (9.4% – 3.6%) = RM103b
Present value of terminal value (PVTV)= TV / (1 + r)ten= RM103b ÷ (1 + 9.4%)ten= RM42b
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total value of equity, which in this case is RM70b. The last step is then to divide the equity value by the number of shares outstanding. From the current stock price of RM8.0, the company appears to be roughly at fair value at a discount of 8.4% from where the stock price is currently trading. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.
We draw your attention to the fact 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 assessment of a company’s future performance, so try the math yourself and check your own assumptions. 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 full picture of a company’s potential performance. Since we view PETRONAS Chemicals Group Berhad as a potential shareholder, 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 9.4%, which is based on a leveraged beta of 0.985. 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 from globally comparable companies, with a limit imposed between 0.8 and 2.0, which is a reasonable range for a stable business.
Move on :
While a business valuation is important, it shouldn’t be the only metric you look at when researching a business. DCF models are not the alpha and omega of investment valuation. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. For PETRONAS Chemicals Group Berhad, we have put together three key factors you should research further:
- Financial health: Does PCHEM 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.
- Future benefits: How does PCHEM’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth expectations chart.
- Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what you might be missing!
PS. Simply Wall St updates its DCF calculation for every Malaysian stock every day, so if you want to find the intrinsic value of any other stock just search here.
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