Calculating The Intrinsic Value Of Silk Road Energy Services Group Limited (HKG:8250)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Silk Road Energy Services Group fair value estimate is HK$0.23
• With HK$0.19 share price, Silk Road Energy Services Group appears to be trading close to its estimated fair value
• When compared to theindustry average discount to fair value of 13%, Silk Road Energy Services Group's competitors seem to be trading at a lesser discount

Does the August share price for Silk Road Energy Services Group Limited (HKG:8250) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

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

See our latest analysis for Silk Road Energy Services Group

Is Silk Road Energy Services Group 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. To start off with, we need to estimate the next ten years of cash flows. 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, 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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (HK$, Millions)	HK$7.19m	HK$7.23m	HK$7.29m	HK$7.38m	HK$7.48m	HK$7.59m	HK$7.71m	HK$7.83m	HK$7.97m	HK$8.10m
Growth Rate Estimate Source	Est @ -0.04%	Est @ 0.51%	Est @ 0.90%	Est @ 1.17%	Est @ 1.36%	Est @ 1.49%	Est @ 1.58%	Est @ 1.65%	Est @ 1.69%	Est @ 1.73%
Present Value (HK$, Millions) Discounted @ 10%	HK$6.5	HK$6.0	HK$5.5	HK$5.0	HK$4.6	HK$4.3	HK$3.9	HK$3.6	HK$3.4	HK$3.1

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = HK$46m

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 1.8%. We discount the terminal cash flows to today's value at a cost of equity of 10%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = HK$8.1m× (1 + 1.8%) ÷ (10%– 1.8%) = HK$100m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= HK$100m÷ ( 1 + 10%)¹⁰= HK$39m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is HK$85m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of HK$0.2, the company appears about fair value at a 18% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

The Assumptions

Now 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 Silk Road Energy Services Group 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 10%, which is based on a levered beta of 1.181. 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.

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Silk Road Energy Services Group, there are three relevant aspects you should further examine:

1. Risks: To that end, you should be aware of the 2 warning signs we've spotted with Silk Road Energy Services Group .
2. 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!
3. Other Environmentally-Friendly Companies: Concerned about the environment and think consumers will buy eco-friendly products more and more? Browse through our interactive list of companies that are thinking about a greener future to discover some stocks you may not have thought of!

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.