Calculating The Fair Value Of Top Standard Corporation (HKG:8510)

Key Insights

• Top Standard's estimated fair value is HK$0.053 based on 2 Stage Free Cash Flow to Equity
• Top Standard's HK$0.058 share price indicates it is trading at similar levels as its fair value estimate
• When compared to theindustry average discount of -30%, Top Standard's competitors seem to be trading at a greater premium to fair value

In this article we are going to estimate the intrinsic value of Top Standard Corporation (HKG:8510) by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for Top Standard

Step By Step Through The Calculation

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (HK$, Millions)	HK$4.21m	HK$4.67m	HK$5.05m	HK$5.36m	HK$5.63m	HK$5.85m	HK$6.05m	HK$6.22m	HK$6.38m	HK$6.53m
Growth Rate Estimate Source	Est @ 14.80%	Est @ 10.90%	Est @ 8.17%	Est @ 6.26%	Est @ 4.92%	Est @ 3.98%	Est @ 3.33%	Est @ 2.87%	Est @ 2.55%	Est @ 2.32%
Present Value (HK$, Millions) Discounted @ 9.1%	HK$3.9	HK$3.9	HK$3.9	HK$3.8	HK$3.6	HK$3.5	HK$3.3	HK$3.1	HK$2.9	HK$2.7

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = HK$35m

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 a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.8%. We discount the terminal cash flows to today's value at a cost of equity of 9.1%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = HK$6.5m× (1 + 1.8%) ÷ (9.1%– 1.8%) = HK$91m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= HK$91m÷ ( 1 + 9.1%)¹⁰= HK$38m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is HK$73m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of HK$0.06, 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. 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 Top Standard 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 9.1%, which is based on a levered beta of 1.043. 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.

SWOT Analysis for Top Standard

Next Steps:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. 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. 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 Top Standard, we've compiled three further items you should further examine:

1. Risks: For instance, we've identified 4 warning signs for Top Standard (2 can't be ignored) you should be aware of.
2. Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!
3. Other Environmentally-Friendly Companies: Concerned about the environment and think consumers will buy eco-friendly products more and more? Browse through our interactive list of companies that are thinking about a greener future to discover some stocks you may not have thought of!

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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.