A Look At The Fair Value Of Riverine China Holdings Limited (HKG:1417)

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Riverine China Holdings Limited (HKG:1417) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

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.

View our latest analysis for Riverine China Holdings

The calculation

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (CN¥, Millions)	CN¥26.2m	CN¥29.3m	CN¥32.0m	CN¥34.1m	CN¥35.9m	CN¥37.3m	CN¥38.6m	CN¥39.6m	CN¥40.6m	CN¥41.4m
Growth Rate Estimate Source	Est @ 16.66%	Est @ 12.11%	Est @ 8.93%	Est @ 6.71%	Est @ 5.15%	Est @ 4.06%	Est @ 3.29%	Est @ 2.76%	Est @ 2.38%	Est @ 2.12%
Present Value (CN¥, Millions) Discounted @ 7.7%	CN¥24.3	CN¥25.3	CN¥25.6	CN¥25.4	CN¥24.8	CN¥24.0	CN¥23.0	CN¥21.9	CN¥20.9	CN¥19.8

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥235m

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 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 7.7%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = CN¥41m× (1 + 1.5%) ÷ (7.7%– 1.5%) = CN¥684m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥684m÷ ( 1 + 7.7%)¹⁰= CN¥327m

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is CN¥562m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of HK$1.8, 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.

The assumptions

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 Riverine China 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 7.7%, which is based on a levered beta of 0.983. 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.

Looking Ahead:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Riverine China Holdings, we've compiled three fundamental elements you should consider:

1. Risks: We feel that you should assess the 2 warning signs for Riverine China Holdings (1 is a bit concerning!) we've flagged before making an investment in the company.
2. 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!
3. Other Top Analyst Picks: Interested to see what the analysts are thinking? Take a look at our interactive list of analysts' top stock picks to find out what they feel might have an attractive future outlook!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the SEHK 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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