KT&G Corporation's (KRX:033780) Intrinsic Value Is Potentially 35% Above Its Share Price

Key Insights

• The projected fair value for KT&G is ₩195,183 based on 2 Stage Free Cash Flow to Equity
• KT&G is estimated to be 26% undervalued based on current share price of ₩144,800
• The ₩173,200 analyst price target for A033780 is 11% less than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of KT&G Corporation (KRX:033780) by taking the forecast future cash flows of the company and discounting them back to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

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The Method

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. 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.

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

	2026	2027	2028	2029	2030	2031	2032	2033	2034	2035
Levered FCF (₩, Millions)	₩1.01t	₩1.02t	₩1.03t	₩1.05t	₩1.08t	₩1.10t	₩1.13t	₩1.16t	₩1.20t	₩1.23t
Growth Rate Estimate Source	Analyst x11	Analyst x10	Est @ 1.56%	Est @ 1.98%	Est @ 2.28%	Est @ 2.49%	Est @ 2.63%	Est @ 2.73%	Est @ 2.80%	Est @ 2.85%
Present Value (₩, Millions) Discounted @ 7.7%	₩933.7k	₩876.2k	₩826.3k	₩782.6k	₩743.3k	₩707.4k	₩674.2k	₩643.2k	₩614.1k	₩586.5k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = ₩7.4t

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 3.0%. We discount the terminal cash flows to today's value at a cost of equity of 7.7%.

Terminal Value (TV)= FCF₂₀₃₅ × (1 + g) ÷ (r – g) = ₩1.2t× (1 + 3.0%) ÷ (7.7%– 3.0%) = ₩27t

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= ₩27t÷ ( 1 + 7.7%)¹⁰= ₩13t

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 ₩20t. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of ₩145k, the company appears a touch undervalued at a 26% discount to where the stock price trades currently. 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.

The Assumptions

Now 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 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 KT&G 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 7.7%, which is based on a levered beta of 0.954. 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.

Check out our latest analysis for KT&G

SWOT Analysis for KT&G

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. 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. Why is the intrinsic value higher than the current share price? For KT&G, we've put together three important items you should look at:

1. Risks: For instance, we've identified 1 warning sign for KT&G that you should be aware of.
2. Future Earnings: How does A033780'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 KOSE 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.