Stock Analysis

# Calculating The Fair Value Of Sinopec Kantons Holdings Limited (HKG:934)

Does the December share price for Sinopec Kantons Holdings Limited (HKG:934) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by projecting its future cash flows and then discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

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.

Check out our latest analysis for Sinopec Kantons Holdings

### The method

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. 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

 2021 2022 2023 2024 2025 2026 2027 2028 2029 2030 Levered FCF (HK\$, Millions) HK\$494.0m HK\$531.0m HK\$558.1m HK\$580.6m HK\$599.6m HK\$616.0m HK\$630.6m HK\$644.0m HK\$656.4m HK\$668.3m Growth Rate Estimate Source Analyst x1 Analyst x1 Est @ 5.11% Est @ 4.03% Est @ 3.27% Est @ 2.74% Est @ 2.37% Est @ 2.11% Est @ 1.93% Est @ 1.81% Present Value (HK\$, Millions) Discounted @ 9.2% HK\$452 HK\$445 HK\$428 HK\$408 HK\$385 HK\$362 HK\$340 HK\$317 HK\$296 HK\$276

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = HK\$3.7b

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 1.5%. We discount the terminal cash flows to today's value at a cost of equity of 9.2%.

Terminal Value (TV)= FCF2030 Ã— (1 + g) Ã· (r â€“ g) = HK\$668mÃ— (1 + 1.5%) Ã· (9.2%â€“ 1.5%) = HK\$8.8b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= HK\$8.8bÃ· ( 1 + 9.2%)10= HK\$3.6b

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\$7.3b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of HK\$2.7, the company appears about fair value at a 7.4% discount to where the stock price trades currently. 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.

### The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Sinopec Kantons 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 9.2%, which is based on a levered beta of 1.264. 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.

### Moving On:

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 Sinopec Kantons Holdings, we've compiled three relevant items you should assess:

1. Risks: To that end, you should be aware of the 1 warning sign we've spotted with Sinopec Kantons Holdings .
2. Future Earnings: How does 934'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. 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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