Today we will run through one way of estimating the intrinsic value of China Lesso Group Holdings Limited (HKG:2128) by projecting its future cash flows and then discounting them to today's value. This is done using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
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.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
|Levered FCF (CN¥, Millions)||CN¥2.54b||CN¥3.18b||CN¥3.18b||CN¥3.20b||CN¥3.23b||CN¥3.26b||CN¥3.30b||CN¥3.34b||CN¥3.39b||CN¥3.44b|
|Growth Rate Estimate Source||Analyst x3||Analyst x3||Est @ 0.15%||Est @ 0.57%||Est @ 0.86%||Est @ 1.07%||Est @ 1.21%||Est @ 1.31%||Est @ 1.38%||Est @ 1.43%|
|Present Value (CN¥, Millions) Discounted @ 9.8%||CN¥2.3k||CN¥2.6k||CN¥2.4k||CN¥2.2k||CN¥2.0k||CN¥1.9k||CN¥1.7k||CN¥1.6k||CN¥1.5k||CN¥1.4k|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥20b
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 (1.6%) 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 9.8%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = CN¥3.4b× (1 + 1.6%) ÷ 9.8%– 1.6%) = CN¥43b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥43b÷ ( 1 + 9.8%)10= CN¥17b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is CN¥36b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of HK$10.5, the company appears about fair value at a 18% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 China Lesso Group Holdings 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 9.8%, which is based on a levered beta of 1.297. 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.
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. For China Lesso Group Holdings, We've compiled three additional aspects you should look at:
- Risks: Take risks, for example - China Lesso Group Holdings has 2 warning signs we think you should be aware of.
- Future Earnings: How does 2128'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: Do you like a good all-rounder? 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 SEHK every day. If you want to find the calculation for other stocks just search here.
If you spot an error that warrants correction, please contact the editor at email@example.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.
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