Does the May share price for Lee and Man Paper Manufacturing Limited (HKG:2314) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to today's value. I will use 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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
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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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
Levered FCF (HK$, Millions)
HK$3.80k
HK$3.77k
HK$4.25k
HK$3.94k
HK$3.75k
HK$3.65k
HK$3.60k
HK$3.59k
HK$3.61k
HK$3.64k
Growth Rate Estimate Source
Analyst x5
Analyst x5
Analyst x4
Analyst x1
Est @ -4.7%
Est @ -2.69%
Est @ -1.28%
Est @ -0.3%
Est @ 0.39%
Est @ 0.88%
Present Value (HK$, Millions) Discounted @ 12.27%
HK$3.39k
HK$2.99k
HK$3.00k
HK$2.48k
HK$2.10k
HK$1.82k
HK$1.60k
HK$1.42k
HK$1.27k
HK$1.14k
Present Value of 10-year Cash Flow (PVCF)= HK$21.22b
"Est" = FCF growth rate estimated by Simply Wall St
After calculating the present value of future cash flows in the intial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 10-year government bond rate (2%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 12.3%.
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = HK$HK$36b ÷ ( 1 + 12.3%)10 = HK$11.35b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is HK$32.57b. The last step is to then divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate of HK$7.44. Relative to the current share price of HK$5.19, the company appears quite undervalued at a 30% 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:2314 Intrinsic value, May 23rd 2019
The 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. 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 Lee and Man Paper Manufacturing 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 12.3%, which is based on a levered beta of 1.545. 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 Lee and Man Paper Manufacturing, I've compiled three further factors you should further research:
Future Earnings: How does 2314'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 2314? 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.
