How far off is CK Hutchison Holdings Limited (HKG:1) from its intrinsic value? Using the most recent financial data, we’ll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to today’s value. This will be 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.
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) estimate
|Levered FCF (HK$, Millions)||HK$39.0b||HK$43.2b||HK$45.1b||HK$46.6b||HK$48.0b||HK$49.2b||HK$50.3b||HK$51.4b||HK$52.4b||HK$53.3b|
|Growth Rate Estimate Source||Analyst x3||Analyst x2||Est @ 4.26%||Est @ 3.47%||Est @ 2.92%||Est @ 2.54%||Est @ 2.27%||Est @ 2.08%||Est @ 1.95%||Est @ 1.86%|
|Present Value (HK$, Millions) Discounted @ 15%||HK$34.0k||HK$32.9k||HK$29.9k||HK$26.9k||HK$24.2k||HK$21.6k||HK$19.3k||HK$17.1k||HK$15.2k||HK$13.5k|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = HK$235b
After calculating the present value of future cash flows in the initial 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 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 15%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = HK$53b× (1 + 1.6%) ÷ (15%– 1.6%) = HK$415b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= HK$415b÷ ( 1 + 15%)10= HK$105b
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$340b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of HK$48.6, the company appears quite undervalued at a 45% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula – garbage in, garbage out.
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company’s future performance, so try the calculation yourself and check your own 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 CK Hutchison 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 15%, which is based on a levered beta of 1.835. 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 is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. 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. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For CK Hutchison Holdings, there are three additional items you should further research:
- Risks: To that end, you should be aware of the 2 warning signs we’ve spotted with CK Hutchison Holdings .
- Future Earnings: How does 1’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.
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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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