A Look At The Intrinsic Value Of Tencent Holdings Limited (HKG:700)

Key Insights

• The projected fair value for Tencent Holdings is HK$437 based on 2 Stage Free Cash Flow to Equity
• Current share price of HK$375 suggests Tencent Holdings is potentially trading close to its fair value
• The CN¥460 analyst price target for 700 is 5.3% more than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of Tencent Holdings Limited (HKG:700) by taking the expected future cash flows and discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. 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.

See our latest analysis for Tencent Holdings

Crunching The Numbers

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. 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.

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) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CN¥, Millions)	CN¥181.0b	CN¥226.0b	CN¥236.7b	CN¥245.2b	CN¥253.0b	CN¥260.3b	CN¥267.2b	CN¥273.9b	CN¥280.4b	CN¥286.9b
Growth Rate Estimate Source	Analyst x13	Analyst x12	Analyst x8	Est @ 3.62%	Est @ 3.18%	Est @ 2.87%	Est @ 2.65%	Est @ 2.50%	Est @ 2.40%	Est @ 2.32%
Present Value (CN¥, Millions) Discounted @ 8.3%	CN¥167.1k	CN¥192.6k	CN¥186.1k	CN¥178.0k	CN¥169.5k	CN¥161.0k	CN¥152.5k	CN¥144.3k	CN¥136.4k	CN¥128.8k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥1.6t

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (2.2%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 8.3%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CN¥287b× (1 + 2.2%) ÷ (8.3%– 2.2%) = CN¥4.7t

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥4.7t÷ ( 1 + 8.3%)¹⁰= CN¥2.1t

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¥3.7t. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of HK$375, the company appears about fair value at a 14% 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

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 Tencent 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 8.3%, which is based on a levered beta of 1.099. 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 Tencent Holdings

Moving On:

Although the valuation of a company is important, 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. 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 Tencent Holdings, we've compiled three relevant elements you should further research:

1. Risks: For instance, we've identified 2 warning signs for Tencent Holdings that you should be aware of.
2. Future Earnings: How does 700'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. 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.