Today we’ll do a simple run through of a valuation method used to estimate the attractiveness of Hi-P International Limited (SGX:H17) as an investment opportunity by estimating the company’s future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Before you think you won’t be able to understand it, just read on! It’s actually much less complex than you’d imagine.
We generally believe that a company’s value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
We’re 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 a stable growth rate. 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, 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 (SGD, Millions)||S$89.6m||S$79.1m||S$74.4m||S$71.8m||S$70.5m||S$70.1m||S$70.2m||S$70.8m||S$71.7m||S$72.7m|
|Growth Rate Estimate Source||Analyst x2||Analyst x2||Est @ -5.91%||Est @ -3.49%||Est @ -1.8%||Est @ -0.62%||Est @ 0.21%||Est @ 0.79%||Est @ 1.2%||Est @ 1.49%|
|Present Value (SGD, Millions) Discounted @ 9.3%||S$81.9||S$66.2||S$56.9||S$50.2||S$45.1||S$41.0||S$37.6||S$34.7||S$32.1||S$29.8|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = S$475m
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 (2.2%) 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 9.3%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = S$73m× (1 + 2.2%) ÷ (9.3%– 2.2%) = S$1.0b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= S$1.0b÷ ( 1 + 9.3%)10= S$423m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is S$898m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of S$1.2, the company appears around fair value at the time of writing. 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. 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 Hi-P International 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 9.3%, which is based on a levered beta of 1.197. 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. Preferably you’d apply different cases and assumptions and see how they would impact the company’s valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Hi-P International, we’ve put together three fundamental factors you should explore:
- Financial Health: Does H17 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.
- Future Earnings: How does H17’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 Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the SGX 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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