Estimating The Fair Value Of D&G Technology Holding Company Limited (HKG:1301)

Today we’ll do a simple run through of a valuation method used to estimate the attractiveness of D&G Technology Holding Company Limited (HKG:1301) as an investment opportunity by estimating the company’s future cash flows and discounting them to their present value. I will be using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

Remember though, that there are many ways to estimate a company’s value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

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Check out our latest analysis for D&G Technology Holding

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 start off with, we need to estimate 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, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

2019 2020 2021 2022 2023 2024 2025 2026 2027 2028
Levered FCF (CN¥, Millions) CN¥25.98 CN¥33.00 CN¥39.45 CN¥45.08 CN¥49.86 CN¥53.86 CN¥57.20 CN¥60.04 CN¥62.48 CN¥64.63
Growth Rate Estimate Source Est @ 37.78% Est @ 27.05% Est @ 19.54% Est @ 14.28% Est @ 10.59% Est @ 8.02% Est @ 6.21% Est @ 4.95% Est @ 4.07% Est @ 3.45%
Present Value (CN¥, Millions) Discounted @ 9.18% CN¥23.79 CN¥27.69 CN¥30.32 CN¥31.73 CN¥32.14 CN¥31.80 CN¥30.94 CN¥29.74 CN¥28.34 CN¥26.86

Present Value of 10-year Cash Flow (PVCF)= CN¥293.34m

“Est” = FCF growth rate estimated by Simply Wall St

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 (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 9.2%.

Terminal Value (TV) = FCF2029 × (1 + g) ÷ (r – g) = CN¥65m × (1 + 2%) ÷ (9.2% – 2%) = CN¥919m

Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = CN¥CN¥919m ÷ ( 1 + 9.2%)10 = CN¥381.76m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is CN¥675.11m. In the final step we divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate in the company’s reported currency of CN¥1.09. However, 1301’s primary listing is in Hong Kong, and 1 share of 1301 in CNY represents 1.142 ( CNY/ HKD) share of SEHK:1301, so the intrinsic value per share in HKD is HK$1.24. Relative to the current share price of HK$1.32, the company appears around fair value at the time of writing. 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.

SEHK:1301 Intrinsic value, May 17th 2019
SEHK:1301 Intrinsic value, May 17th 2019

The assumptions

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 D&G Technology Holding 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 9.2%, which is based on a levered beta of 1.079. 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.

Next Steps:

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. For D&G Technology Holding, There are three important aspects you should further examine:

  1. Financial Health: Does 1301 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.
  2. Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of 1301? 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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.