Estimating The Fair Value Of Nine Dragons Paper (Holdings) Limited (HKG:2689)

In this article we are going to estimate the intrinsic value of Nine Dragons Paper (Holdings) Limited (HKG:2689) by estimating the company's future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

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 Nine Dragons Paper (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. To start off with, we need to estimate 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (CN¥, Millions)	-CN¥9.73b	CN¥4.12b	CN¥4.91b	CN¥5.60b	CN¥6.16b	CN¥6.63b	CN¥7.01b	CN¥7.32b	CN¥7.59b	CN¥7.81b
Growth Rate Estimate Source	Analyst x3	Analyst x3	Est @ 19.22%	Est @ 13.9%	Est @ 10.17%	Est @ 7.57%	Est @ 5.74%	Est @ 4.46%	Est @ 3.57%	Est @ 2.94%
Present Value (CN¥, Millions) Discounted @ 12%	-CN¥8.7k	CN¥3.3k	CN¥3.5k	CN¥3.5k	CN¥3.5k	CN¥3.3k	CN¥3.1k	CN¥2.9k	CN¥2.7k	CN¥2.5k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥20b

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 1.5%. We discount the terminal cash flows to today's value at a cost of equity of 12%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = CN¥7.8b× (1 + 1.5%) ÷ (12%– 1.5%) = CN¥74b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥74b÷ ( 1 + 12%)¹⁰= CN¥23b

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¥43b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of HK$10.7, the company appears about fair value at a 2.3% 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

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. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Nine Dragons Paper (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 12%, which is based on a levered beta of 1.990. 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 ideally won't be the sole piece of analysis you scrutinize 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. 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 Nine Dragons Paper (Holdings), there are three important elements you should further research:

1. Risks: For example, we've discovered 2 warning signs for Nine Dragons Paper (Holdings) (1 makes us a bit uncomfortable!) that you should be aware of before investing here.
2. Future Earnings: How does 2689'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 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!

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.
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