Calculating The Intrinsic Value Of Yuan Heng Gas Holdings Limited (HKG:332)

Today we will run through one way of estimating the intrinsic value of Yuan Heng Gas Holdings Limited (HKG:332) by estimating the company's future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Yuan Heng Gas Holdings

Is Yuan Heng Gas Holdings fairly valued?

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. 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

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (CN¥, Millions)	CN¥61.8m	CN¥91.9m	CN¥123.5m	CN¥153.8m	CN¥181.0m	CN¥204.1m	CN¥223.3m	CN¥239.0m	CN¥251.8m	CN¥262.3m
Growth Rate Estimate Source	Est @ 68.75%	Est @ 48.57%	Est @ 34.44%	Est @ 24.55%	Est @ 17.63%	Est @ 12.79%	Est @ 9.39%	Est @ 7.02%	Est @ 5.36%	Est @ 4.19%
Present Value (CN¥, Millions) Discounted @ 11%	CN¥56.0	CN¥75.2	CN¥91.5	CN¥103	CN¥110	CN¥112	CN¥111	CN¥107	CN¥102	CN¥96.5

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥964m

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 (1.5%) 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 11%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = CN¥262m× (1 + 1.5%) ÷ (11%– 1.5%) = CN¥2.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥2.9b÷ ( 1 + 11%)¹⁰= CN¥1.1b

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¥2.0b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of HK$0.3, the company appears about fair value at a 19% 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. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Yuan Heng Gas Holdings 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 11%, which is based on a levered beta of 1.703. 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.

Next Steps:

Whilst important, the DCF calculation is only one of many factors that you need to assess for 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. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Yuan Heng Gas Holdings, we've compiled three fundamental items you should further examine:

1. Risks: Be aware that Yuan Heng Gas Holdings is showing 2 warning signs in our investment analysis , you should know about...
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for 332's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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.

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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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