In this article, we will estimate the intrinsic value of Top Glove Corporation Bhd. (KLSE: TOPGLOV) by taking expected future cash flows and discounting them to their present value. One way to do this is to use the Discounted Cash Flow (DCF) model. It may sound complicated, but it’s actually quite simple!

We draw your attention to the fact that there are many ways to assess a business and, like DCF, each technique has advantages and disadvantages in certain scenarios. For those who are passionate about equity analysis, the Simply Wall St analysis template here may be of interest to you.

Check out our latest review for Top Glove Corporation Bhd

The method

We use what is called a two-step model, which simply means that we have two different periods of growth rate for the cash flow of the business. Usually, the first stage is higher growth, and the second stage is a lower growth stage. To begin with, we need to estimate the next ten years of cash flow. 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 need to discount the sum of these future cash flows to arrive at an estimate of the present value:

10-year free cash flow (FCF) forecast

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = RM8.0b

We now need to calculate the Terminal Value, which takes into account all future cash flows after this ten year period. 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 8.4%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = RM1.6b × (1 + 3.6%) ÷ (8.4% – 3.6%) = RM35b

Present value of terminal value (PVTV)= TV / (1 + r)^ten= RM35b ÷ (1 + 8.4%)^ten= RM15b

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 RM23b. The last step is then to divide the equity value by the number of shares outstanding. From the current RM2.7 share price, the company appears to be roughly at fair value with a 7.7% discount from where the share price is currently trading. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.

Important assumptions

The above calculation is very dependent on two assumptions. One is the discount rate and the other is cash flow. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play with them. 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 complete picture of a company’s potential performance. Since we consider Top Glove Corporation Bhd 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 takes into account the debt. In this calculation, we used 8.4%, which is based on a leveraged beta of 0.891. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

To move on :

While valuing a business is important, it’s just one of the many factors you need to assess for a business. The DCF model is not a perfect equity valuation tool. 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, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. For Top Glove Corporation Bhd, we have compiled three important aspects that you should consider:

1. Risks: To this end, you should inquire about the 4 warning signs we spotted with Top Glove Corporation Bhd (2 of which cannot be ignored).
2. Management: Have insiders increased their shares to take advantage of market sentiment about TOPGLOV’s future prospects? Check out our management and board analysis with information on CEO compensation and governance factors.
3. Other strong companies: 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 trading fundamentals to see if there are other companies you may not have considered!

PS. The Simply Wall St app performs a daily discounted cash flow assessment for each KLSE share. If you want to find the calculation for other actions, do a search here.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in any of the stocks mentioned.

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