Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of SINOPEC Engineering (Group) Co., Ltd. (HKG:2386) as an investment opportunity by projecting its future cash flows and then discounting them to today’s value. I will be using the Discounted Cash Flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. Please also note that this article was written in January 2019 so be sure check out the updated calculation by following the link below.
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Step by step through the calculation
I use what is known as a 2-stage model, which simply means we have two different periods of varying growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a more stable growth phase. To begin with we have to get estimates of the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. The sum of these cash flows is then discounted to today’s value.
5-year cash flow estimate
|Levered FCF (CN¥, Millions)||CN¥3.20k||CN¥3.28k||CN¥3.14k||CN¥3.00k||CN¥2.87k|
|Source||Analyst x2||Analyst x2||Est @ -4.38%||Est @ -4.38%||Est @ -4.38%|
|Present Value Discounted @ 8.4%||CN¥2.95k||CN¥2.79k||CN¥2.47k||CN¥2.17k||CN¥1.92k|
Present Value of 5-year Cash Flow (PVCF)= CN¥12b
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 the GDP. In this case I have used the 10-year government bond rate (2%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 8.4%.
Terminal Value (TV) = FCF2023 × (1 + g) ÷ (r – g) = CN¥2.9b × (1 + 2%) ÷ (8.4% – 2%) = CN¥46b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = CN¥46b ÷ ( 1 + 8.4%)5 = CN¥31b
The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is CN¥43b. To get the intrinsic value per share, we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR. This results in an intrinsic value of HK$11.07. Relative to the current share price of HK$7.26, the stock is quite undervalued at a 34% discount to what it is available for right now.
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. You don’t have to agree with my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at SINOPEC Engineering (Group) as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 8.4%, which is based on a levered beta of 0.800. This is derived from the Bottom-Up Beta method based on 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. What is the reason for the share price to differ from the intrinsic value? For 2386, I’ve put together three relevant aspects you should further research:
- Financial Health: Does 2386 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 2386’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: Are there other high quality stocks you could be holding instead of 2386? 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 for every stock on the HKG every 6 hours. If you want to find the calculation for other stocks just search here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.