Today we will run through one way of estimating the intrinsic value of CK Asset Holdings Limited (HKG:1113) by projecting its future cash flows and then discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
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 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.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) estimate
|Levered FCF (HK$, Millions)||HK$13.4b||HK$13.7b||HK$14.0b||HK$14.3b||HK$14.5b||HK$14.7b||HK$15.0b||HK$15.2b||HK$15.4b||HK$15.7b|
|Growth Rate Estimate Source||Analyst x2||Analyst x2||Est @ 1.93%||Est @ 1.79%||Est @ 1.7%||Est @ 1.63%||Est @ 1.59%||Est @ 1.56%||Est @ 1.53%||Est @ 1.52%|
|Present Value (HK$, Millions) Discounted @ 8.1%||HK$12.4k||HK$11.8k||HK$11.1k||HK$10.4k||HK$9.8k||HK$9.2k||HK$8.7k||HK$8.1k||HK$7.6k||HK$7.2k|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = HK$96b
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 8.1%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = HK$16b× (1 + 1.5%) ÷ (8.1%– 1.5%) = HK$240b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= HK$240b÷ ( 1 + 8.1%)10= HK$110b
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$206b. 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$52.2, the company appears about fair value at a 7.9% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.
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 CK Asset 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 8.1%, which is based on a levered beta of 1.356. 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.
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. 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 CK Asset Holdings, there are three further items you should further research:
- Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with CK Asset Holdings , and understanding this should be part of your investment process.
- Future Earnings: How does 1113'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.
- 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. 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.