Estimating The Fair Value Of Sumitomo Electric Industries, Ltd. (TSE:5802)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Sumitomo Electric Industries fair value estimate is JP¥5,516
• Sumitomo Electric Industries' JP¥6,325 share price indicates it is trading at similar levels as its fair value estimate
• Our fair value estimate is 17% lower than Sumitomo Electric Industries' analyst price target of JP¥6,611

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Sumitomo Electric Industries, Ltd. (TSE:5802) as an investment opportunity by taking the expected 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.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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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The Calculation

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. 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2026	2027	2028	2029	2030	2031	2032	2033	2034	2035
Levered FCF (¥, Millions)	JP¥139.1b	JP¥222.1b	JP¥182.2b	JP¥212.4b	JP¥251.4b	JP¥261.5b	JP¥269.2b	JP¥275.3b	JP¥280.2b	JP¥284.1b
Growth Rate Estimate Source	Analyst x4	Analyst x4	Analyst x4	Analyst x3	Analyst x3	Est @ 3.99%	Est @ 2.97%	Est @ 2.26%	Est @ 1.76%	Est @ 1.41%
Present Value (¥, Millions) Discounted @ 6.4%	JP¥130.7k	JP¥196.1k	JP¥151.2k	JP¥165.6k	JP¥184.3k	JP¥180.1k	JP¥174.2k	JP¥167.4k	JP¥160.1k	JP¥152.6k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = JP¥1.7t

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. 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 6.4%.

Terminal Value (TV)= FCF₂₀₃₅ × (1 + g) ÷ (r – g) = JP¥284b× (1 + 0.6%) ÷ (6.4%– 0.6%) = JP¥4.9t

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= JP¥4.9t÷ ( 1 + 6.4%)¹⁰= JP¥2.6t

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¥4.3t. The last step is to then divide the equity value by the 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. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Sumitomo Electric Industries 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 6.4%, which is based on a levered beta of 1.108. 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 Sumitomo Electric Industries

SWOT Analysis for Sumitomo Electric Industries

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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. 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 Sumitomo Electric Industries, we've compiled three further items you should consider:

1. Risks: Be aware that Sumitomo Electric Industries is showing 2 warning signs in our investment analysis , and 1 of those is significant...
2. Future Earnings: How does 5802'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.

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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.