Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of Greentown Service Group Co. Ltd. (HKG:2869) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. I will use the Discounted Cash Flows (DCF) model. It may sound complicated, but actually it is quite simple! If you want to learn more about discounted cash flow, the basis for my calcs can be read in detail in the Simply Wall St analysis model. If you are reading this and its not January 2019 then I highly recommend you check out the latest calculation for Greentown Service Group by following the link below.
Check out our latest analysis for Greentown Service Group
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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. In the first stage we need to estimate the cash flows to the business over the next five years. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount the sum of these cash flows to arrive at a present value estimate.
5-year cash flow estimate
| 2019 | 2020 | 2021 | 2022 | 2023 | |
| Levered FCF (CN¥, Millions) | CN¥776.20 | CN¥988.00 | CN¥1.38k | CN¥1.59k | CN¥1.69k |
| Source | Analyst x5 | Analyst x5 | Analyst x1 | Analyst x1 | Analyst x1 |
| Present Value Discounted @ 8.57% | CN¥714.95 | CN¥838.22 | CN¥1.08k | CN¥1.14k | CN¥1.12k |
Present Value of 5-year Cash Flow (PVCF)= CN¥4.9b
The second stage is also known as Terminal Value, this is the business’s cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 2.2%. We discount this to today’s value at a cost of equity of 8.6%.
Terminal Value (TV) = FCF2023 × (1 + g) ÷ (r – g) = CN¥1.7b × (1 + 2.2%) ÷ (8.6% – 2.2%) = CN¥27b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = CN¥27b ÷ ( 1 + 8.6%)5 = CN¥18b
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¥23b. The last step is to then divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) then we use the equivalent number. This results in an intrinsic value of HK$9.38. Relative to the current share price of HK$6.52, the stock is quite undervalued at a 31% discount to what it is available for right now.
The assumptions
I’d like to point out that 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 my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Greentown Service 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 8.6%, which is based on a levered beta of 0.816. 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.
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. What is the reason for the share price to differ from the intrinsic value? For 2869, I’ve put together three fundamental aspects you should look at:
- Financial Health: Does 2869 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 2869’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 2869? 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 does a DCF calculation for every HK stock every 6 hours, so if you want to find the intrinsic value of any other stock 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 editorial-team@simplywallst.com.