Today we will run through one way of estimating the intrinsic value of Health and Happiness (H&H) International Holdings Limited (HKG:1112) by taking the expected future cash flows and discounting them to their present 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'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. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or 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 (CN¥, Millions)
CN¥1.59b
CN¥1.83b
CN¥1.81b
CN¥1.93b
CN¥2.01b
CN¥2.09b
CN¥2.16b
CN¥2.22b
CN¥2.28b
CN¥2.33b
Growth Rate Estimate Source
Analyst x5
Analyst x5
Analyst x2
Analyst x2
Est @ 4.5%
Est @ 3.75%
Est @ 3.23%
Est @ 2.86%
Est @ 2.6%
Est @ 2.42%
Present Value (CN¥, Millions) Discounted @ 7.3%
CN¥1.5k
CN¥1.6k
CN¥1.5k
CN¥1.5k
CN¥1.4k
CN¥1.4k
CN¥1.3k
CN¥1.3k
CN¥1.2k
CN¥1.1k
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = CN¥14b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 7.3%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥45b÷ ( 1 + 7.3%)10= CN¥22b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is CN¥36b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of HK$35.0, the company appears quite undervalued at a 44% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
SEHK:1112 Intrinsic value, November 11th 2019
The assumptions
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Health and Happiness (H&H) International 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 7.3%, which is based on a levered beta of 0.800. 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. What is the reason for the share price to differ from the intrinsic value? For Health and Happiness (H&H) International Holdings, There are three fundamental factors you should further examine:
Future Earnings: How does 1112'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 1112? 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.
