Are Investors Undervaluing Kobe Steel, Ltd. (TSE:5406) By 29%?

Key Insights

• The projected fair value for Kobe Steel is JP¥2,878 based on 2 Stage Free Cash Flow to Equity
• Kobe Steel is estimated to be 29% undervalued based on current share price of JP¥2,055
• The JP¥1,976 analyst price target for 5406 is 31% less than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of Kobe Steel, Ltd. (TSE:5406) by taking the forecast future cash flows of the company and discounting them back to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

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.

AI is about to change healthcare. These 20 stocks are working on everything from early diagnostics to drug discovery. The best part - they are all under $10bn in marketcap - there is still time to get in early.

The 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. 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, 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¥184.0b	JP¥70.6b	JP¥75.1b	JP¥85.6b	JP¥87.0b	JP¥87.9b	JP¥88.7b	JP¥89.5b	JP¥90.2b	JP¥90.8b
Growth Rate Estimate Source	Est @ 1.26%	Analyst x3	Analyst x3	Analyst x2	Analyst x2	Est @ 1.06%	Est @ 0.92%	Est @ 0.83%	Est @ 0.76%	Est @ 0.71%
Present Value (¥, Millions) Discounted @ 8.7%	JP¥169.4k	JP¥59.8k	JP¥58.6k	JP¥61.4k	JP¥57.5k	JP¥53.4k	JP¥49.6k	JP¥46.1k	JP¥42.7k	JP¥39.6k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = JP¥638b

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 0.6%. We discount the terminal cash flows to today's value at a cost of equity of 8.7%.

Terminal Value (TV)= FCF₂₀₃₅ × (1 + g) ÷ (r – g) = JP¥91b× (1 + 0.6%) ÷ (8.7%– 0.6%) = JP¥1.1t

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= JP¥1.1t÷ ( 1 + 8.7%)¹⁰= JP¥495b

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 JP¥1.1t. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of JP¥2.1k, the company appears a touch undervalued at a 29% 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.

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Kobe Steel 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 8.7%, which is based on a levered beta of 1.533. 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 Kobe Steel

SWOT Analysis for Kobe Steel

Next Steps:

Although the valuation of a company is important, 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. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Kobe Steel, we've put together three pertinent elements you should assess:

1. Risks: You should be aware of the 3 warning signs for Kobe Steel (1 is potentially serious!) we've uncovered before considering an investment in the company.
2. Future Earnings: How does 5406'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 Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

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.