Today we are going to do a simple overview of a valuation method used to estimate the attractiveness of YG Entertainment Inc. (KOSDAQ: 122870) as an investment opportunity by taking expected future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model for this purpose. There really isn’t much to do, although it may seem quite complex.
We draw your attention to the fact that there are many ways to value a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in learning a little more about intrinsic value should read the Simply Wall St Analysis Template.
We use the 2-stage growth model, which simply means that we consider two stages of business growth. In the initial period, the company may have a higher growth rate, and the second stage is generally assumed to have a stable growth rate. To start, we need to estimate the cash flows for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported 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 more in early years than in later years.
Generally, we assume that a dollar today is worth more than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at an estimate of present value:
10-Year Free Cash Flow (FCF) Forecast
|Leveraged FCF (₩, Millions)||₩21.8b||₩44.8b||₩65.2b||₩86.8b||₩107.9b||₩127.4b||₩144.9b||₩160.5b||₩174.3b||₩186.8b|
|Growth rate estimate Source||Analyst x7||Analyst x4||Is at 45.69%||Is at 33.09%||Is at 24.27%||Is at 18.09%||Is at 13.77%||Is at 10.74%||Is at 8.62%||Is at 7.14%|
|Present value (₩, millions) discounted at 10.0%||₩19.8k||₩37.0k||₩49.0k||₩59.3k||₩67.1k||₩72.0k||₩74.5k||₩75.0k||₩74.1k||₩72.2k|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = ₩600b
After calculating the present value of future cash flows over the initial 10-year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first stage. For a number of reasons, a very conservative growth rate is used which cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (3.7%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 10.0%.
Terminal value (TV)= FCF2030 × (1 + g) ÷ (r – g) = ₩187b × (1 + 3.7%) ÷ (10.0%– 3.7%) = ₩3.1t
Present value of terminal value (PVTV)= TV / (1 + r)ten= ₩3.1t÷ ( 1 + 10.0%)ten= ₩1.2t
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is ₩1.8t. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of ₩49,000, the company seems to have pretty good value at a 50% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.
Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flows. If you disagree with these results, try the math yourself and play around with the assumptions. 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 YG Entertainment 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 debt into account. In this calculation, we used 10.0%, which is based on a leveraged beta of 1.057. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Let’s move on :
Valuation is only one side of the coin in terms of crafting your investment thesis, and ideally it won’t be the only piece of analysis you look at for a company. The DCF model is not a perfect stock valuation tool. Instead, the best use of 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 pace, or if its cost of equity or risk-free rate changes sharply, output may be very different. Can we understand why the company is trading at a discount to its intrinsic value? For YG Entertainment, we have compiled three relevant aspects that you should consider in more detail:
- Financial health: Does A122870 have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors such as leverage and risk.
- Future earnings: How does A122870’s growth rate compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
- Other strong companies: Low debt, high returns on equity and good past performance are essential to a strong business. Why not explore our interactive list of stocks with strong trading fundamentals to see if there are any other businesses you may not have considered!
PS. The Simply Wall St app performs an updated cash flow assessment for each KOSDAQ stock every day. If you want to find the calculation for other stocks just search here.
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This Simply Wall St article is general in nature. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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