Today we will run through one way of estimating the intrinsic value of China Energy Development Holdings Limited (HKG:228) by estimating the company's future cash flows and discounting them to their present value. I will use 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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
Step by step through the calculation
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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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, 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
|Levered FCF (HK$, Millions)||HK$62.6m||HK$79.8m||HK$95.6m||HK$109.3m||HK$120.7m||HK$130.1m||HK$137.8m||HK$144.2m||HK$149.5m||HK$154.0m|
|Growth Rate Estimate Source||Est @ 38.68%||Est @ 27.54%||Est @ 19.75%||Est @ 14.29%||Est @ 10.47%||Est @ 7.79%||Est @ 5.92%||Est @ 4.61%||Est @ 3.69%||Est @ 3.05%|
|Present Value (HK$, Millions) Discounted @ 7.6%||HK$58.2||HK$68.9||HK$76.7||HK$81.4||HK$83.5||HK$83.7||HK$82.3||HK$80.0||HK$77.1||HK$73.8|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = HK$765m
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 10-year government bond rate of 1.6%. We discount the terminal cash flows to today's value at a cost of equity of 7.6%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = HK$154m× (1 + 1.6%) ÷ 7.6%– 1.6%) = HK$2.6b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= HK$2.6b÷ ( 1 + 7.6%)10= HK$1.2b
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$2.0b. 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$0.2, the company appears about fair value at a 2.8% 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.
We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 China Energy Development 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 7.6%, which is based on a levered beta of 1.003. 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 China Energy Development Holdings, I've put together three fundamental aspects you should further research:
- Financial Health: Does 228 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.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of 228? 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 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.
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