Is There An Opportunity With China Communications Services Corporation Limited’s (HKG:552) 22.69% Undervaluation?

Simply Wall St.

Fri, Oct 19, 2018, 8:34 PM

Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of China Communications Services Corporation Limited (HKG:552) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. I will be using the Discounted Cash Flows (DCF) model. It may sound complicated, but actually it is quite simple! If you want to learn more about discounted cash flow, the basis for my calcs can be read in detail in the Simply Wall St analysis model. Please also note that this article was written in October 2018 so be sure check out the updated calculation by following the link below.

Check out our latest analysis for China Communications Services

Is 552 fairly valued?

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second ‘steady growth’ period. To start off with we need to estimate the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount the sum of these cash flows to arrive at a present value estimate.

5-year cash flow estimate

	2019	2020	2021	2022	2023
Levered FCF (CN¥, Millions)	CN¥2.64k	CN¥3.04k	CN¥3.31k	CN¥3.59k	CN¥3.90k
Source	Analyst x3	Analyst x2	Est @ 8.66%	Est @ 8.66%	Est @ 8.66%
Present Value Discounted @ 8.82%	CN¥2.43k	CN¥2.57k	CN¥2.57k	CN¥2.56k	CN¥2.56k

Present Value of 5-year Cash Flow (PVCF)= CN¥12.7b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after the five years. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (2.2%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 8.8%.

Terminal Value (TV) = FCF₂₀₂₂ × (1 + g) ÷ (r – g) = CN¥3.9b × (1 + 2.2%) ÷ (8.8% – 2.2%) = CN¥60.3b

Present Value of Terminal Value (PVTV) = TV / (1 + r)⁵ = CN¥60.3b ÷ ( 1 + 8.8%)⁵ = CN¥39.5b

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¥52.2b. The last step is to then divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) then we use the equivalent number. This results in an intrinsic value in the company’s reported currency of CN¥7.53. However, 552’s primary listing is in China, and 1 share of 552 in CNY represents 1.13 ( CNY/ HKD) share of SEHK:552, so the intrinsic value per share in HKD is HK$8.51. Compared to the current share price of HK$6.58, the stock is about right, perhaps slightly undervalued at a 23% discount to what it is available for right now.

SEHK:552 Intrinsic Value Export October 20th 18

Important assumptions

Now 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 my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at China Communications Services 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 8.8%, which is based on a levered beta of 0.849. 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:

Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For 552, there are three fundamental factors you should look at:

Financial Health: Does 552 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.
Future Earnings: How does 552’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 552? 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.

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