In this article I am going to calculate the intrinsic value of Tencent Holdings Limited (HKG:700) by taking the expected future cash flows and discounting them to today’s value. I will use 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. If you are reading this and its not November 2018 then I highly recommend you check out the latest calculation for Tencent Holdings by following the link below.

View our latest analysis for Tencent Holdings

Step by step through the calculation

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¥606.8b

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 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 11.1%.

Terminal Value (TV) = FCF₂₀₂₂ × (1 + g) ÷ (r – g) = CN¥214.1b × (1 + 2.2%) ÷ (11.1% – 2.2%) = CN¥2.5t

Present Value of Terminal Value (PVTV) = TV / (1 + r)⁵ = CN¥2.5t ÷ ( 1 + 11.1%)⁵ = CN¥1.5t

The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is CN¥2.1t. In the final step we 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) or ADR then we use the equivalent number. This results in an intrinsic value in the company’s reported currency of CN¥218.51. However, 700’s primary listing is in China, and 1 share of 700 in CNY represents 1.135 ( CNY/ HKD) share of OTCPK:TCTZ.F, so the intrinsic value per share in HKD is HK$248.06. Relative to the current share price of HK$303.6, the stock is fair value, maybe slightly overvalued and not available at a discount at this time.

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 Tencent Holdings 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 11.1%, which is based on a levered beta of 1.137. 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. What is the reason for the share price to differ from the intrinsic value? For 700, I’ve compiled three pertinent factors you should look at:

1. Financial Health: Does 700 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 700’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 700? 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 for every stock on the HKG every 6 hours. If you want to find the calculation for other stocks 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.