Today we’ll do a simple run through of a valuation method used to estimate the attractiveness of Dimension Computer Technology Co., Ltd. (GTSM:6140) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. This will be done using 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 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.

See our latest analysis for Dimension Computer Technology

The model

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. 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 discount the value of these future cash flows to their estimated value in today’s dollars:

10-year free cash flow (FCF) forecast

2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
Levered FCF (NT$, Millions) NT$92.8m NT$86.6m NT$82.8m NT$80.5m NT$79.1m NT$78.3m NT$78.0m NT$77.9m NT$78.1m NT$78.4m
Growth Rate Estimate Source Est @ -9.83% Est @ -6.63% Est @ -4.39% Est @ -2.83% Est @ -1.73% Est @ -0.96% Est @ -0.42% Est @ -0.05% Est @ 0.22% Est @ 0.4%
Present Value (NT$, Millions) Discounted @ 8.3% NT$85.7 NT$73.8 NT$65.2 NT$58.5 NT$53.1 NT$48.5 NT$44.6 NT$41.2 NT$38.1 NT$35.3

(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NT$544m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (0.8%) 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 8.3%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = NT$78m× (1 + 0.8%) ÷ (8.3%– 0.8%) = NT$1.1b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= NT$1.1b÷ ( 1 + 8.3%)10= NT$477m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is NT$1.0b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of NT$22.7, the company appears about fair value at a 15% discount to where the stock price trades currently. 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
GTSM:6140 Discounted Cash Flow December 21st 2020

Important 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. 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 Dimension Computer Technology 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 8.3%, which is based on a levered beta of 1.220. 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.

Looking Ahead:

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. 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. For Dimension Computer Technology, we’ve put together three further factors you should assess:

  1. Risks: We feel that you should assess the 2 warning signs for Dimension Computer Technology we’ve flagged before making an investment in the company.
  2. 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!
  3. Other Top Analyst Picks: Interested to see what the analysts are thinking? Take a look at our interactive list of analysts’ top stock picks to find out what they feel might have an attractive future outlook!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the GTSM 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. 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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