Calculating The Fair Value Of Precious Dragon Technology Holdings Limited (HKG:1861)

Key Insights

• Precious Dragon Technology Holdings' estimated fair value is HK$1.13 based on 2 Stage Free Cash Flow to Equity
• Precious Dragon Technology Holdings' HK$1.27 share price indicates it is trading at similar levels as its fair value estimate
• When compared to theindustry average discount of -163%, Precious Dragon Technology Holdings' competitors seem to be trading at a greater premium to fair value

In this article we are going to estimate the intrinsic value of Precious Dragon Technology Holdings Limited (HKG:1861) by taking the forecast future cash flows of the company and discounting them back 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.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for Precious Dragon Technology Holdings

The Model

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. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (HK$, Millions)	HK$25.5m	HK$20.3m	HK$17.6m	HK$16.1m	HK$15.2m	HK$14.7m	HK$14.5m	HK$14.5m	HK$14.6m	HK$14.7m
Growth Rate Estimate Source	Est @ -29.79%	Est @ -20.15%	Est @ -13.41%	Est @ -8.68%	Est @ -5.38%	Est @ -3.06%	Est @ -1.44%	Est @ -0.31%	Est @ 0.49%	Est @ 1.04%
Present Value (HK$, Millions) Discounted @ 7.4%	HK$23.7	HK$17.6	HK$14.2	HK$12.1	HK$10.6	HK$9.6	HK$8.8	HK$8.2	HK$7.6	HK$7.2

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = HK$120m

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 7.4%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = HK$15m× (1 + 2.3%) ÷ (7.4%– 2.3%) = HK$296m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= HK$296m÷ ( 1 + 7.4%)¹⁰= HK$145m

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$264m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of HK$1.3, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Precious Dragon Technology 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 7.4%, which is based on a levered beta of 1.020. 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:

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. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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 Precious Dragon Technology Holdings, there are three important elements you should further research:

1. Risks: We feel that you should assess the 3 warning signs for Precious Dragon Technology Holdings (1 makes us a bit uncomfortable!) we've flagged before making an investment in the company.
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 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.