Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Mediwelcome Healthcare Management & Technology Inc. (HKG:2159) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Believe it or not, it's not too difficult to follow, as you'll see from our example!
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
What's the estimated valuation?
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.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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
|Levered FCF (CN¥, Millions)||CN¥7.60m||CN¥8.31m||CN¥8.88m||CN¥9.35m||CN¥9.74m||CN¥10.1m||CN¥10.4m||CN¥10.6m||CN¥10.8m||CN¥11.0m|
|Growth Rate Estimate Source||Est @ 12.62%||Est @ 9.28%||Est @ 6.94%||Est @ 5.3%||Est @ 4.15%||Est @ 3.35%||Est @ 2.79%||Est @ 2.4%||Est @ 2.12%||Est @ 1.93%|
|Present Value (CN¥, Millions) Discounted @ 5.9%||CN¥7.2||CN¥7.4||CN¥7.5||CN¥7.4||CN¥7.3||CN¥7.1||CN¥6.9||CN¥6.7||CN¥6.5||CN¥6.2|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥70m
The second stage is also known as Terminal Value, this is the business's cash flow after 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 5.9%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = CN¥11m× (1 + 1.5%) ÷ (5.9%– 1.5%) = CN¥254m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥254m÷ ( 1 + 5.9%)10= CN¥144m
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¥214m. 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$1.2, the company appears about fair value at a 8.0% 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.
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 Mediwelcome Healthcare Management & Technology 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 5.9%, which is based on a levered beta of 0.891. 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.
Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for 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. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For Mediwelcome Healthcare Management & Technology, we've put together three relevant elements you should assess:
- Risks: For instance, we've identified 5 warning signs for Mediwelcome Healthcare Management & Technology (1 is a bit concerning) you should be aware of.
- 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!
- 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. Simply Wall St updates its DCF calculation for every Hong Kong stock every day, so if you want to find the intrinsic value of any other stock 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.