Today we'll do a simple run through of a valuation method used to estimate the attractiveness of CNNC International Limited (HKG:2302) as an investment opportunity by taking the foreast future cash flows of the company and discounting them back 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. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
We're 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 a stable growth rate. To start off with, we need to estimate the next ten years of cash flows. 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.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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$46.5m
HK$63.8m
HK$80.7m
HK$96.2m
HK$109.7m
HK$121.1m
HK$130.7m
HK$138.7m
HK$145.5m
HK$151.3m
Growth Rate Estimate Source
Est @ 52.09%
Est @ 37.06%
Est @ 26.55%
Est @ 19.18%
Est @ 14.03%
Est @ 10.42%
Est @ 7.9%
Est @ 6.13%
Est @ 4.89%
Est @ 4.02%
Present Value (HK$, Millions) Discounted @ 9.0%
HK$42.7
HK$53.7
HK$62.3
HK$68.1
HK$71.2
HK$72.2
HK$71.4
HK$69.5
HK$66.9
HK$63.8
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = HK$641m
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 (2.0%) 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 9.0%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= HK$2.2b÷ ( 1 + 9.0%)10= HK$928m
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$1.6b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of HK$2.9, the company appears about fair value at a 9.0% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.
SEHK:2302 Intrinsic value, September 26th 2019
Important assumptions
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. If you don't agree with these result, have a go at the calculation yourself and play with the assumptions. 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 CNNC International 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 9.0%, which is based on a levered beta of 1.055. 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:
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 CNNC International, I've put together three fundamental factors you should further research:
Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of 2302? 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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
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.
