Stock Analysis

# Calculating The Intrinsic Value Of CNOOC Limited (HKG:883)

### Key Insights

• Using the 2 Stage Free Cash Flow to Equity, CNOOC fair value estimate is HK\$15.07
• With HK\$12.26 share price, CNOOC appears to be trading close to its estimated fair value
• The CN¥16.38 analyst price target for 883 is 8.7% more than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of CNOOC Limited (HKG:883) 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.

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 want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

View our latest analysis for CNOOC

## 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. To begin with, we have to get estimates of 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, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

#### 10-year free cash flow (FCF) forecast

 2024 2025 2026 2027 2028 2029 2030 2031 2032 2033 Levered FCF (CN¥, Millions) CN¥95.6b CN¥94.6b CN¥57.4b CN¥59.3b CN¥51.8b CN¥47.4b CN¥45.0b CN¥43.6b CN¥42.9b CN¥42.7b Growth Rate Estimate Source Analyst x5 Analyst x4 Analyst x2 Analyst x1 Est @ -12.75% Est @ -8.33% Est @ -5.24% Est @ -3.08% Est @ -1.56% Est @ -0.50% Present Value (CN¥, Millions) Discounted @ 9.1% CN¥87.7k CN¥79.5k CN¥44.2k CN¥41.9k CN¥33.5k CN¥28.1k CN¥24.4k CN¥21.7k CN¥19.6k CN¥17.9k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥398b

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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 9.1%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = CN¥43b× (1 + 2.0%) ÷ (9.1%– 2.0%) = CN¥610b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥610b÷ ( 1 + 9.1%)10= CN¥255b

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¥654b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of HK\$12.3, 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

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. 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 CNOOC 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 9.1%, which is based on a levered beta of 1.206. 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 CNOOC

Strength
• Earnings growth over the past year exceeded the industry.
• Debt is not viewed as a risk.
• Dividends are covered by earnings and cash flows.
• Dividend is in the top 25% of dividend payers in the market.
Weakness
• Earnings growth over the past year is below its 5-year average.
Opportunity
• Good value based on P/E ratio and estimated fair value.
Threat
• Annual earnings are forecast to decline for the next 3 years.

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. 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 CNOOC, there are three additional items you should look at:

1. Risks: Every company has them, and we've spotted 2 warning signs for CNOOC (of which 1 can't be ignored!) you should know about.
2. Future Earnings: How does 883'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. 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.