Today we’ll do a simple run through of a valuation method used to estimate the attractiveness of Fairwood Holdings Limited (HKG:52) as an investment opportunity by taking the expected future cash flows and discounting them to today’s value. This is done using the Discounted Cash Flow (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward.
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.
What’s the estimated valuation?
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.
Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today’s dollars:
10-year free cash flow (FCF) forecast
|Levered FCF (HK$, Millions)||HK$273.0m||HK$330.0m||HK$361.6m||HK$387.7m||HK$409.1m||HK$427.0m||HK$442.1m||HK$455.3m||HK$467.0m||HK$477.7m|
|Growth Rate Estimate Source||Analyst x1||Analyst x1||Est @ 9.59%||Est @ 7.2%||Est @ 5.53%||Est @ 4.37%||Est @ 3.55%||Est @ 2.98%||Est @ 2.57%||Est @ 2.29%|
|Present Value (HK$, Millions) Discounted @ 11%||HK$246||HK$268||HK$264||HK$255||HK$242||HK$227||HK$212||HK$197||HK$182||HK$167|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = HK$2.3b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 11%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = HK$478m× (1 + 1.6%) ÷ 11%– 1.6%) = HK$5.2b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= HK$5.2b÷ ( 1 + 11%)10= HK$1.8b
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$4.1b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of HK$16.0, the company appears quite good value at a 49% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope – move a few degrees and end up in a different galaxy. Do keep this in mind.
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. If you don’t agree with these result, have a go at the calculation yourself and play with the 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 Fairwood 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 11%, which is based on a levered beta of 1.324. 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. What is the reason for the share price to differ from the intrinsic value? For Fairwood Holdings, There are three relevant aspects you should further research:
- Risks: You should be aware of the 2 warning signs for Fairwood Holdings we’ve uncovered before considering an investment in the company.
- Future Earnings: How does 52’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. Simply Wall St updates its DCF calculation for every HK stock every day, so if you want to find the intrinsic value of any other stock just search here.
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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned. Thank you for reading.