Are Investors Undervaluing DRB-HICOM Berhad (KLSE:DRBHCOM) By 37%?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, DRB-HICOM Berhad fair value estimate is RM2.21

• Current share price of RM1.39 suggests DRB-HICOM Berhad is potentially 37% undervalued

• The RM1.61 analyst price target for DRBHCOM is 27% less than our estimate of fair value

In this article we are going to estimate the intrinsic value of DRB-HICOM Berhad (KLSE:DRBHCOM) by projecting its future cash flows and then discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Don't get put off by the jargon, the math behind it is actually quite straightforward.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

View our latest analysis for DRB-HICOM Berhad

The Calculation

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 start off with, we need to estimate 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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (MYR, Millions)	-RM620.3m	RM1.11b	RM931.6m	RM835.6m	RM784.3m	RM758.9m	RM749.8m	RM751.5m	RM760.7m	RM775.3m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ -16.23%	Est @ -10.30%	Est @ -6.14%	Est @ -3.24%	Est @ -1.20%	Est @ 0.22%	Est @ 1.22%	Est @ 1.92%
Present Value (MYR, Millions) Discounted @ 16%	-RM534	RM823	RM593	RM458	RM369	RM307	RM261	RM225	RM196	RM172

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = RM2.9b

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 3.6%. We discount the terminal cash flows to today's value at a cost of equity of 16%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = RM775m× (1 + 3.6%) ÷ (16%– 3.6%) = RM6.3b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= RM6.3b÷ ( 1 + 16%)¹⁰= RM1.4b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is RM4.3b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of RM1.4, the company appears quite good value at a 37% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 DRB-HICOM Berhad 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 16%, which is based on a levered beta of 2.000. 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.

SWOT Analysis for DRB-HICOM Berhad

Strength

• Debt is well covered by cash flow.

• Dividends are covered by earnings and cash flows.

Weakness

• Earnings declined over the past year.

• Interest payments on debt are not well covered.

• Dividend is low compared to the top 25% of dividend payers in the Auto market.

Opportunity

• Annual earnings are forecast to grow faster than the Malaysian market.

• Good value based on P/E ratio and estimated fair value.

Threat

• Annual revenue is forecast to grow slower than the Malaysian market.

Next Steps:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price sitting below the intrinsic value? For DRB-HICOM Berhad, we've put together three important aspects you should look at:

1. Risks: Every company has them, and we've spotted 1 warning sign for DRB-HICOM Berhad you should know about.

2. Future Earnings: How does DRBHCOM'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. Simply Wall St updates its DCF calculation for every Malaysian stock every day, so if you want to find the intrinsic value of any other stock 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com