Estimating The Fair Value Of Shandong Molong Petroleum Machinery Company Limited (HKG:568)

Key Insights

• Shandong Molong Petroleum Machinery's estimated fair value is HK$0.83 based on 2 Stage Free Cash Flow to Equity
• Current share price of HK$0.88 suggests Shandong Molong Petroleum Machinery is potentially trading close to its fair value
• The average discount for Shandong Molong Petroleum Machinery's competitorsis currently 47%

How far off is Shandong Molong Petroleum Machinery Company Limited (HKG:568) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by projecting its future cash flows and then discounting them to today's value. Our analysis will employ 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.

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. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out our latest analysis for Shandong Molong Petroleum Machinery

Is Shandong Molong Petroleum Machinery Fairly Valued?

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.

Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (CN¥, Millions)	CN¥77.8m	CN¥71.5m	CN¥68.0m	CN¥66.1m	CN¥65.2m	CN¥65.1m	CN¥65.4m	CN¥66.1m	CN¥67.0m	CN¥68.1m
Growth Rate Estimate Source	Est @ -12.45%	Est @ -8.04%	Est @ -4.95%	Est @ -2.79%	Est @ -1.28%	Est @ -0.22%	Est @ 0.52%	Est @ 1.04%	Est @ 1.40%	Est @ 1.66%
Present Value (CN¥, Millions) Discounted @ 12%	CN¥69.3	CN¥56.8	CN¥48.1	CN¥41.7	CN¥36.7	CN¥32.6	CN¥29.2	CN¥26.3	CN¥23.8	CN¥21.5

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥386m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 2.3%. We discount the terminal cash flows to today's value at a cost of equity of 12%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = CN¥68m× (1 + 2.3%) ÷ (12%– 2.3%) = CN¥700m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥700m÷ ( 1 + 12%)¹⁰= CN¥221m

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¥607m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of HK$0.9, the company appears around fair value at the time of writing. 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. 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 Shandong Molong Petroleum Machinery 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.

SWOT Analysis for Shandong Molong Petroleum Machinery

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching 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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Shandong Molong Petroleum Machinery, there are three fundamental items you should explore:

1. Risks: For instance, we've identified 1 warning sign for Shandong Molong Petroleum Machinery that you should be aware of.
2. 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!
3. Other Top Analyst Picks: Interested to see what the analysts are thinking? Take a look at our interactive list of analysts' top stock picks to find out what they feel might have an attractive future outlook!

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. 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.

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