Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of Zhaojin Mining Industry Company Limited (HKG:1818) as an investment opportunity by estimating the company’s future cash flows and discounting them to their present value. I will be using the Discounted Cash Flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. Please also note that this article was written in September 2018 so be sure check out the updated calculation by following the link below.

View our latest analysis for Zhaojin Mining Industry

The model

I’m 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 perpetual stable growth rate. In the first stage we need to estimate the cash flows to the business over the next five years. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount this to its value today and sum up the total to get the present value of these cash flows.

5-year cash flow estimate

Present Value of 5-year Cash Flow (PVCF)= CN¥5.00b

The second stage is also known as Terminal Value, this is the business’s cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 2.2%. We discount this to today’s value at a cost of equity of 10.7%.

Terminal Value (TV) = FCF₂₀₂₂ × (1 + g) ÷ (r – g) = CN¥1.50b × (1 + 2.2%) ÷ (10.7% – 2.2%) = CN¥18.09b

Present Value of Terminal Value (PVTV) = TV / (1 + r)⁵ = CN¥18.09b ÷ ( 1 + 10.7%)⁵ = CN¥10.90b

The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is CN¥15.90b. To get the intrinsic value per share, we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR. This results in an intrinsic value in the company’s reported currency of CN¥4.94. However, 1818’s primary listing is in China, and 1 share of 1818 in CNY represents 1.143 ( CNY/ HKD) share of SEHK:1818, so the intrinsic value per share in HKD is HK$5.64. Relative to the current share price of HK$6.07, the stock is fair value, maybe slightly overvalued at the time of writing.

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don’t agree with my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Zhaojin Mining Industry as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 10.7%, which is based on a levered beta of 1.084. This is derived from the Bottom-Up Beta method based on 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. For 1818, I’ve put together three essential aspects you should further examine:

1. Financial Health: Does 1818 have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.

2. Future Earnings: How does 1818’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.

3. Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of 1818? 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 does a DCF calculation for every HK stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.