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Does the July share price for Grand Ming Group Holdings Limited (HKG:1271) reflect what it’s really worth? Today, we will estimate the stock’s intrinsic value by taking the expected future cash flows and discounting them to their present value. I will use 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.
Crunching the numbers
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. To begin with, we have to get estimates of the next ten years of cash flows. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company’s last 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 (HK$, Millions)||HK$159.2m||HK$224.2m||HK$289.7m||HK$350.8m||HK$404.6m||HK$450.4m||HK$488.9m||HK$521.0m||HK$548.2m||HK$571.4m|
|Growth Rate Estimate Source||Est @ 57.55%||Est @ 40.88%||Est @ 29.22%||Est @ 21.05%||Est @ 15.34%||Est @ 11.34%||Est @ 8.54%||Est @ 6.58%||Est @ 5.21%||Est @ 4.24%|
|Present Value (HK$, Millions) Discounted @ 12.94%||HK$140.9||HK$175.8||HK$201.1||HK$215.6||HK$220.1||HK$217.0||HK$208.5||HK$196.8||HK$183.3||HK$169.2|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF)= HK$1.9b
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 (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 12.9%.
Terminal Value (TV) = FCF2029 × (1 + g) ÷ (r – g) = HK$571m × (1 + 2%) ÷ (12.9% – 2%) = HK$5.3b
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = HK$HK$5.3b ÷ ( 1 + 12.9%)10 = HK$1.58b
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$3.51b. The last step is to then divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate of HK$4.94. Compared to the current share price of HK$4.7, the company appears about fair value at a 4.9% 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. 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 Grand Ming 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 12.9%, which is based on a levered beta of 1.645. 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.
Whilst important, DCF calculation 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 Grand Ming Group Holdings, I’ve compiled three further factors you should look at:
- Financial Health: Does 1271 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.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of 1271? 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 HKG every day. If you want to find the calculation for other stocks just search here.
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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. Thank you for reading.