In this article we are going to estimate the intrinsic value of Chinasoft International Limited (HKG:354) by taking the expected future cash flows and discounting them to their present value. I will be using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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.
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We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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.
Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
Levered FCF (CN¥, Millions)
CN¥745.81
CN¥555.90
CN¥733.50
CN¥879.45
CN¥1.01k
CN¥1.12k
CN¥1.21k
CN¥1.28k
CN¥1.35k
CN¥1.40k
Growth Rate Estimate Source
Analyst x2
Analyst x4
Analyst x2
Est @ 19.9%
Est @ 14.53%
Est @ 10.77%
Est @ 8.14%
Est @ 6.3%
Est @ 5.01%
Est @ 4.11%
Present Value (CN¥, Millions) Discounted @ 9.17%
CN¥683.15
CN¥466.41
CN¥563.71
CN¥619.09
CN¥649.46
CN¥658.97
CN¥652.74
CN¥635.56
CN¥611.33
CN¥582.97
Present Value of 10-year Cash Flow (PVCF)= CN¥6.12b
"Est" = FCF growth rate estimated by Simply Wall St
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%) 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 9.2%.
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = CN¥CN¥20b ÷ ( 1 + 9.2%)10 = CN¥8.29b
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 CN¥14.42b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. This results in an intrinsic value estimate in the company’s reported currency of CN¥5.75. However, 354’s primary listing is in China, and 1 share of 354 in CNY represents 1.135 ( CNY/ HKD) share of SEHK:354, so the intrinsic value per share in HKD is HK$6.53. Relative to the current share price of HK$3.66, the company appears quite good value 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:354 Intrinsic value, May 19th 2019
Important assumptions
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 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 Chinasoft 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 9.2%, which is based on a levered beta of 1.203. 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:
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. 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 Chinasoft International, There are three essential factors you should further examine:
Future Earnings: How does 354'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 354? 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 HKG every day. If you want to find the calculation for other stocks 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.
