Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of Aluminum Corporation of China Limited (HKG:2600) as an investment opportunity by taking the expected future cash flows and discounting them to today’s value. This is done using the Discounted Cash Flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. If you want to learn more about discounted cash flow, the basis for my calcs can be read in detail in the Simply Wall St analysis model. Please also note that this article was written in November 2018 so be sure check out the updated calculation by following the link below.
I use what is known as a 2-stage model, which simply means we have two different periods of varying growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a more stable growth phase. In the first stage we need to estimate the cash flows to the business over the next five years. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount this to its value today and sum up the total to get the present value of these cash flows.
5-year cash flow estimate
|Levered FCF (CN¥, Millions)||CN¥6.80k||CN¥9.31k||CN¥9.51k||CN¥9.72k||CN¥9.94k|
|Source||Analyst x1||Analyst x3||Est @ 2.22%||Est @ 2.22%||Est @ 2.22%|
|Present Value Discounted @ 13.87%||CN¥5.97k||CN¥7.18k||CN¥6.44k||CN¥5.78k||CN¥5.19k|
Present Value of 5-year Cash Flow (PVCF)= CN¥30.6b
After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 2.2%. We discount this to today’s value at a cost of equity of 13.9%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = CN¥9.9b × (1 + 2.2%) ÷ (13.9% – 2.2%) = CN¥87.1b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = CN¥87.1b ÷ ( 1 + 13.9%)5 = CN¥45.5b
The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is CN¥76.1b. To get the intrinsic value per share, we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR. This results in an intrinsic value in the company’s reported currency of CN¥5.1. However, 2600’s primary listing is in China, and 1 share of 2600 in CNY represents 1.135 ( CNY/ HKD) share of NYSE:ACH, so the intrinsic value per share in HKD is HK$5.79. Relative to the current share price of HK$3.02, the stock is quite undervalued at a 48% discount to what it is available for right now.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don’t have to agree with my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at Aluminum of China as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 13.9%, which is based on a levered beta of 1.496. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For 2600, I’ve put together three important factors you should further examine:
- Financial Health: Does 2600 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 2600’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 2600? 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 does a DCF calculation for every HK stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.