Today we will run through one way of estimating the intrinsic value of Yanzhou Coal Mining Company Limited (HKG:1171) by taking the expected future cash flows and discounting them to today's value. I will use the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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 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, 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 (CN¥, Millions)||CN¥1.38b||CN¥10.8b||CN¥6.88b||CN¥4.95b||CN¥4.00b||CN¥3.49b||CN¥3.19b||CN¥3.01b||CN¥2.91b||CN¥2.85b|
|Growth Rate Estimate Source||Analyst x1||Analyst x4||Analyst x2||Est @ -28.01%||Est @ -19.14%||Est @ -12.93%||Est @ -8.59%||Est @ -5.55%||Est @ -3.42%||Est @ -1.93%|
|Present Value (CN¥, Millions) Discounted @ 14%||CN¥1.2k||CN¥8.3k||CN¥4.6k||CN¥2.9k||CN¥2.1k||CN¥1.6k||CN¥1.3k||CN¥1.0k||CN¥879||CN¥755|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥25b
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 (1.6%) 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 14%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = CN¥2.9b× (1 + 1.6%) ÷ 14%– 1.6%) = CN¥23b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥23b÷ ( 1 + 14%)10= CN¥6.1b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is CN¥31b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of HK$5.8, the company appears about fair value at a 15% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
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. 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 Yanzhou Coal Mining 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 14%, 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.
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 Yanzhou Coal Mining, We've compiled three additional factors you should further research:
- Risks: We feel that you should assess the 2 warning signs for Yanzhou Coal Mining we've flagged before making an investment in the company.
- Future Earnings: How does 1171'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: Do you like a good all-rounder? 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.
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