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# Sinopec Shanghai Petrochemical Company Limited (HKG:338) Is Trading At A 24.83% Discount

I am going to run you through how I calculated the intrinsic value of Sinopec Shanghai Petrochemical Company Limited (HKG:338) by estimating the company’s future cash flows and discounting them to their present value. I will use the Discounted Cash Flows (DCF) model. It may sound complicated, but actually it is quite simple! 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.

### The method

I’m using the 2-stage growth model, which simply means we take in account two stages of company’s growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have perpetual stable growth rate. To begin with we have to get estimates of the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount the sum of these cash flows to arrive at a present value estimate.

#### 5-year cash flow estimate

 2019 2020 2021 2022 2023 Levered FCF (CN¥, Millions) CN¥5.12k CN¥5.14k CN¥4.93k CN¥4.73k CN¥4.53k Source Analyst x1 Analyst x4 Est @ -4.12% Est @ -4.12% Est @ -4.12% Present Value Discounted @ 11.63% CN¥4.59k CN¥4.13k CN¥3.55k CN¥3.05k CN¥2.62k

Present Value of 5-year Cash Flow (PVCF)= CN¥17.9b

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 the GDP. In this case I have used the 10-year government bond rate (2.2%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 11.6%.

Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = CN¥4.5b × (1 + 2.2%) ÷ (11.6% – 2.2%) = CN¥49.2b

Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = CN¥49.2b ÷ ( 1 + 11.6%)5 = CN¥28.4b

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¥46.3b. In the final step we 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) or ADR then we use the equivalent number. This results in an intrinsic value in the company’s reported currency of CN¥4.28. However, 338’s primary listing is in China, and 1 share of 338 in CNY represents 1.132 ( CNY/ HKD) share of NYSE:SHI, so the intrinsic value per share in HKD is HK\$4.84. Compared to the current share price of HK\$3.64, the stock is about right, perhaps slightly undervalued at a 25% discount to what it is available for right now.

### The assumptions

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 Sinopec Shanghai Petrochemical 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 11.6%, which is based on a levered beta of 1.209. 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.

### Next Steps:

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. What is the reason for the share price to differ from the intrinsic value? For 338, there are three relevant factors you should look at:

1. Financial Health: Does 338 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.
2. Future Earnings: How does 338’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.
3. Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of 338? 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 editorial-team@simplywallst.com.