Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Xinyi Glass Holdings Limited (HKG:868) as an investment opportunity by taking the foreast future cash flows of the company and discounting them back to today's value. This is done using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
Is Xinyi Glass Holdings fairly valued?
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 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.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) forecast
|Levered FCF (HK$, Millions)||HK$2.14b||HK$2.76b||HK$3.23b||HK$3.63b||HK$3.97b||HK$4.25b||HK$4.48b||HK$4.69b||HK$4.86b||HK$5.02b|
|Growth Rate Estimate Source||Analyst x3||Analyst x3||Est @ 16.89%||Est @ 12.42%||Est @ 9.3%||Est @ 7.11%||Est @ 5.58%||Est @ 4.5%||Est @ 3.75%||Est @ 3.23%|
|Present Value (HK$, Millions) Discounted @ 11%||HK$1.9k||HK$2.2k||HK$2.4k||HK$2.4k||HK$2.3k||HK$2.3k||HK$2.2k||HK$2.0k||HK$1.9k||HK$1.8k|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = HK$21b
The second stage is also known as Terminal Value, this is the business's cash flow after 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 (2.0%) 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 11%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = HK$5.0b× (1 + 2.0%) ÷ 11%– 2.0%) = HK$56b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= HK$56b÷ ( 1 + 11%)10= HK$20b
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$41b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of HK$9.4, the company appears about fair value at a 7.9% discount to where the stock price trades currently. 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 Xinyi Glass Holdings 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 11%, which is based on a levered beta of 1.364. 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.
Valuation is only one side of the coin in terms of building your investment thesis, and it 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 Xinyi Glass Holdings, I've put together three relevant factors you should further research:
- Financial Health: Does 868 have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does 868'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 868? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the SEHK every day. If you want to find the calculation for other stocks just search here.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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