In this article we are going to estimate the intrinsic value of China Petroleum & Chemical Corporation (HKG:386) by estimating the company’s future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Believe it or not, it’s not too difficult to follow, as you’ll see from our example!
Remember though, that there are many ways to estimate a company’s value, and a DCF is just one method. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
Is China Petroleum & Chemical 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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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) estimate
|Levered FCF (CN¥, Millions)||CN¥24.5b||CN¥30.8b||CN¥35.5b||CN¥39.5b||CN¥42.8b||CN¥45.5b||CN¥47.7b||CN¥49.6b||CN¥51.2b||CN¥52.6b|
|Growth Rate Estimate Source||Analyst x2||Analyst x2||Est @ 15.26%||Est @ 11.17%||Est @ 8.31%||Est @ 6.31%||Est @ 4.91%||Est @ 3.93%||Est @ 3.24%||Est @ 2.76%|
|Present Value (CN¥, Millions) Discounted @ 13%||CN¥21.6k||CN¥24.0k||CN¥24.4k||CN¥23.9k||CN¥22.9k||CN¥21.5k||CN¥19.9k||CN¥18.2k||CN¥16.6k||CN¥15.1k|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥208b
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 a country’s GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (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 13%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = CN¥53b× (1 + 1.6%) ÷ (13%– 1.6%) = CN¥458b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥458b÷ ( 1 + 13%)10= CN¥131b
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is CN¥339b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of HK$3.5, the company appears around fair value at the time of writing. 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. 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 China Petroleum & Chemical 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 13%, which is based on a levered beta of 1.600. 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. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or 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 Petroleum & Chemical, there are three additional aspects you should further examine:
- Risks: Case in point, we’ve spotted 2 warning signs for China Petroleum & Chemical you should be aware of, and 1 of them is a bit concerning.
- Future Earnings: How does 386’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 Hong Kong 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.
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