In this article we are going to estimate the intrinsic value of CIMC Enric Holdings Limited (HKG:3899) by taking the expected future cash flows and discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. It may sound complicated, but actually it is quite simple!
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.
Crunching the numbers
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 begin with, we have to get estimates of 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, 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 (CN¥, Millions)||CN¥567.0m||CN¥876.0m||CN¥973.9m||CN¥1.05b||CN¥1.12b||CN¥1.17b||CN¥1.22b||CN¥1.26b||CN¥1.29b||CN¥1.32b|
|Growth Rate Estimate Source||Analyst x2||Analyst x3||Est @ 11.18%||Est @ 8.27%||Est @ 6.23%||Est @ 4.81%||Est @ 3.81%||Est @ 3.11%||Est @ 2.62%||Est @ 2.28%|
|Present Value (CN¥, Millions) Discounted @ 7.3%||CN¥528||CN¥760||CN¥787||CN¥794||CN¥786||CN¥767||CN¥742||CN¥713||CN¥682||CN¥649|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥7.2b
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 5-year average of the 10-year government bond yield (1.5%) 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 7.3%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = CN¥1.3b× (1 + 1.5%) ÷ (7.3%– 1.5%) = CN¥23b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥23b÷ ( 1 + 7.3%)10= CN¥11b
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¥18b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of HK$7.6, the company appears quite undervalued at a 30% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
We would point out that 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 these inputs, I recommend redoing the calculations yourself and playing with them. 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 CIMC Enric 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 7.3%, which is based on a levered beta of 1.085. 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, the DCF calculation ideally won't be the sole piece of analysis you scrutinize 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. Why is the intrinsic value higher than the current share price? For CIMC Enric Holdings, there are three important elements you should further examine:
- Risks: You should be aware of the 1 warning sign for CIMC Enric Holdings we've uncovered before considering an investment in the company.
- Future Earnings: How does 3899'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. Simply Wall St updates its DCF calculation for every Hong Kong stock every day, so if you want to find the intrinsic value of any other stock 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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