An Intrinsic Calculation For China Coal Energy Company Limited (HKG:1898) Suggests It's 53% Undervalued

In this article we are going to estimate the intrinsic value of China Coal Energy Company Limited (HKG:1898) by projecting its future cash flows and then discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Believe it or not, it's not too difficult to follow, as you'll see from our example!

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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

See our latest analysis for China Coal Energy

Step by step through the calculation

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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) estimate

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (CN¥, Millions)	CN¥20.8b	CN¥8.78b	CN¥13.0b	CN¥12.4b	CN¥12.0b	CN¥11.7b	CN¥11.7b	CN¥11.6b	CN¥11.7b	CN¥11.8b
Growth Rate Estimate Source	Analyst x1	Analyst x1	Analyst x1	Est @ -5.19%	Est @ -3.19%	Est @ -1.79%	Est @ -0.81%	Est @ -0.12%	Est @ 0.36%	Est @ 0.7%
Present Value (CN¥, Millions) Discounted @ 12%	CN¥18.5k	CN¥7.0k	CN¥9.2k	CN¥7.8k	CN¥6.7k	CN¥5.9k	CN¥5.2k	CN¥4.6k	CN¥4.1k	CN¥3.7k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥73b

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. 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 1.5%. We discount the terminal cash flows to today's value at a cost of equity of 12%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = CN¥12b× (1 + 1.5%) ÷ (12%– 1.5%) = CN¥110b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥110b÷ ( 1 + 12%)¹⁰= CN¥35b

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¥107b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of HK$4.6, the company appears potentially underpriced at a discount of over 50%. For me this isn't a good thing, we should try and work out why the stock appears cheap in this model. Do the inputs we've used seem reasonable? Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 China Coal Energy 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 12%, which is based on a levered beta of 2.000. 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:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. 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. What is the reason for the share price sitting below the intrinsic value? For China Coal Energy, we've put together three fundamental factors you should assess:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 4 warning signs with China Coal Energy (at least 1 which shouldn't be ignored) , and understanding these should be part of your investment process.
2. Future Earnings: How does 1898'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 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!

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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