A Look At The Fair Value Of China Oilfield Services Limited (HKG:2883)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, China Oilfield Services fair value estimate is HK$8.53
• Current share price of HK$8.22 suggests China Oilfield Services is potentially trading close to its fair value
• The CN¥11.02 analyst price target for 2883 is 29% more than our estimate of fair value

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of China Oilfield Services Limited (HKG:2883) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

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.

Check out our latest analysis for China Oilfield Services

Crunching The Numbers

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. 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.

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 (CN¥, Millions)	-CN¥728.5m	CN¥4.02b	CN¥4.39b	CN¥4.69b	CN¥4.95b	CN¥5.16b	CN¥5.34b	CN¥5.50b	CN¥5.64b	CN¥5.77b
Growth Rate Estimate Source	Analyst x2	Analyst x3	Est @ 9.15%	Est @ 6.93%	Est @ 5.37%	Est @ 4.28%	Est @ 3.52%	Est @ 2.99%	Est @ 2.61%	Est @ 2.35%
Present Value (CN¥, Millions) Discounted @ 13%	-CN¥643	CN¥3.1k	CN¥3.0k	CN¥2.8k	CN¥2.6k	CN¥2.4k	CN¥2.2k	CN¥2.0k	CN¥1.8k	CN¥1.7k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥21b

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 (1.7%) 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 13%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = CN¥5.8b× (1 + 1.7%) ÷ (13%– 1.7%) = CN¥51b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥51b÷ ( 1 + 13%)¹⁰= CN¥15b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is CN¥36b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of HK$8.2, the company appears about fair value at a 3.6% discount to where the stock price trades currently. 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.

Important 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 Oilfield Services 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 13%, which is based on a levered beta of 1.617. 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 China Oilfield Services

Next Steps:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. 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. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For China Oilfield Services, we've compiled three important items you should explore:

1. Risks: Take risks, for example - China Oilfield Services has 3 warning signs we think you should be aware of.
2. Future Earnings: How does 2883'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. 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.