How far off is China Tobacco International (HK) Company Limited (HKG:6055) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to their present value. I will use the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
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.
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. To begin with, we have to get estimates of the next ten years of cash flows. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
|Levered FCF (HK$, Millions)||HK$791.4m||HK$821.1m||HK$847.7m||HK$871.9m||HK$894.7m||HK$916.3m||HK$937.4m||HK$958.1m||HK$978.7m||HK$999.3m|
|Growth Rate Estimate Source||Est @ 4.51%||Est @ 3.76%||Est @ 3.23%||Est @ 2.86%||Est @ 2.61%||Est @ 2.42%||Est @ 2.3%||Est @ 2.21%||Est @ 2.15%||Est @ 2.1%|
|Present Value (HK$, Millions) Discounted @ 7.67%||HK$735.0||HK$708.3||HK$679.1||HK$648.8||HK$618.3||HK$588.2||HK$558.8||HK$530.5||HK$503.3||HK$477.3|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF)= HK$6.0b
After calculating the present value of future cash flows in the intial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 10-year government bond rate (2%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 7.7%.
Terminal Value (TV) = FCF2029 × (1 + g) ÷ (r – g) = HK$999m × (1 + 2%) ÷ (7.7% – 2%) = HK$18b
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = HK$HK$18b ÷ ( 1 + 7.7%)10 = HK$8.59b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is HK$14.64b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. This results in an intrinsic value estimate of HK$21.16. Compared to the current share price of HK$23.2, the company appears around fair value at the time of writing. 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.
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 China Tobacco International (HK) 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 0.852. 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.
Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/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. For China Tobacco International (HK), I've compiled three further aspects you should further research:
- Future Earnings: How does 6055'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.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of 6055? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. Simply Wall St updates its DCF calculation for every HK stock every day, so if you want to find the intrinsic value of any other stock just search here.
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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.