Today we'll do a simple run through of a valuation method used to estimate the attractiveness of New Provenance Everlasting Holdings Limited (HKG:2326) as an investment opportunity by taking the foreast future cash flows of the company and discounting them back to today's value. I will be using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.
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. 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.
Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) estimate
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
Levered FCF (HK$, Millions)
HK$147.4m
HK$91.4m
HK$67.6m
HK$55.7m
HK$49.2m
HK$45.5m
HK$43.3m
HK$42.1m
HK$41.6m
HK$41.5m
Growth Rate Estimate Source
Est @ -55.16%
Est @ -38.01%
Est @ -26%
Est @ -17.6%
Est @ -11.72%
Est @ -7.6%
Est @ -4.72%
Est @ -2.7%
Est @ -1.29%
Est @ -0.3%
Present Value (HK$, Millions) Discounted @ 10.38%
HK$133.6
HK$75.0
HK$50.3
HK$37.5
HK$30.0
HK$25.1
HK$21.7
HK$19.1
HK$17.1
HK$15.4
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF)= HK$424.9m
After calculating the present value of future cash flows in the intial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 10-year government bond rate of 2%. We discount the terminal cash flows to today's value at a cost of equity of 10.4%.
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = HK$HK$505m ÷ ( 1 + 10.4%)10 = HK$188.01m
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is HK$612.96m. In the final step we divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate of HK$0.029. Relative to the current share price of HK$0.024, the company appears about fair value at a 17% 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.
SEHK:2326 Intrinsic value, August 16th 2019
Important 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 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 New Provenance Everlasting 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 10.4%, which is based on a levered beta of 1.26. 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.
Next Steps:
Although the valuation of a company is important, 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 New Provenance Everlasting Holdings, I've put together three pertinent factors you should further research:
Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of 2326? 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 updates its DCF calculation for every HK stock every day, so if you want to find the intrinsic value of any other stock just search here.
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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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. Thank you for reading.
