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How far off is China Dongxiang (Group) Co., Ltd. (HKG:3818) from its intrinsic value? Using the most recent financial data, I am going to take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to their present value. This is done using the discounted cash flows (DCF) model. It may sound complicated, but actually it is quite simple! Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. Please also note that this article was written in February 2019 so be sure check out the updated calculation by following the link below.
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 five years. The sum of these cash flows is then discounted to today’s value.
5-year cash flow forecast
|Levered FCF (CN¥, Millions)||CN¥547.60||CN¥554.34||CN¥561.17||CN¥568.08||CN¥575.08|
|Source||Est @ 1.23%||Est @ 1.23%||Est @ 1.23%||Est @ 1.23%||Est @ 1.23%|
|Present Value Discounted @ 8.4%||CN¥505.16||CN¥471.75||CN¥440.55||CN¥411.42||CN¥384.21|
Present Value of 5-year Cash Flow (PVCF)= CN¥2.2b
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. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (2%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 8.4%.
Terminal Value (TV) = FCF2023 × (1 + g) ÷ (r – g) = CN¥575m × (1 + 2%) ÷ (8.4% – 2%) = CN¥9.2b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = CN¥9.2b ÷ ( 1 + 8.4%)5 = CN¥6.1b
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is CN¥8.3b. The last step is to then divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) then we use the equivalent number. This results in an intrinsic value of HK$1.65. Relative to the current share price of HK$1.17, the stock is about right, perhaps slightly undervalued at a 29% discount to what it is available for right now.
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 my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at China Dongxiang (Group) 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 8.4%, which is based on a levered beta of 0.800. 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 3818, there are three relevant aspects you should further examine:
- Financial Health: Does 3818 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 3818’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 3818? 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 for every stock on the HKG every 6 hours. If you want to find the calculation for other stocks 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.