Is There An Opportunity With COSCO SHIPPING Energy Transportation Co., Ltd.'s (HKG:1138) 49% Undervaluation?

Today we will run through one way of estimating the intrinsic value of COSCO SHIPPING Energy Transportation Co., Ltd. (HKG:1138) by taking the expected future cash flows and discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

Check out the opportunities and risks within the HK Oil and Gas industry.

Crunching The Numbers

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. To start off with, we need to estimate 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, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (CN¥, Millions)	CN¥1.66b	CN¥2.44b	CN¥3.06b	CN¥3.61b	CN¥4.09b	CN¥4.49b	CN¥4.81b	CN¥5.08b	CN¥5.31b	CN¥5.49b
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ 25.19%	Est @ 18.12%	Est @ 13.17%	Est @ 9.7%	Est @ 7.28%	Est @ 5.58%	Est @ 4.39%	Est @ 3.56%
Present Value (CN¥, Millions) Discounted @ 9.4%	CN¥1.5k	CN¥2.0k	CN¥2.3k	CN¥2.5k	CN¥2.6k	CN¥2.6k	CN¥2.6k	CN¥2.5k	CN¥2.4k	CN¥2.2k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥23b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 (1.6%) 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 9.4%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = CN¥5.5b× (1 + 1.6%) ÷ (9.4%– 1.6%) = CN¥71b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥71b÷ ( 1 + 9.4%)¹⁰= CN¥29b

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¥52b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of HK$6.1, the company appears quite good value at a 49% 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.

Important Assumptions

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. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 COSCO SHIPPING Energy Transportation 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 9.4%, which is based on a levered beta of 1.435. 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.

Moving On:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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. Why is the intrinsic value higher than the current share price? For COSCO SHIPPING Energy Transportation, there are three relevant factors you should further research:

1. Risks: Case in point, we've spotted 2 warning signs for COSCO SHIPPING Energy Transportation you should be aware of, and 1 of them is a bit concerning.
2. Future Earnings: How does 1138'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.
3. 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. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.