Calculating The Intrinsic Value Of Wenling Zhejiang Measuring and Cutting Tools Trading Centre Company Limited (HKG:1379)

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Wenling Zhejiang Measuring and Cutting Tools Trading Centre Company Limited (HKG:1379) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. 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. 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 Wenling Zhejiang Measuring and Cutting Tools Trading Centre

Step by step through the calculation

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. 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) forecast

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (CN¥, Millions)	CN¥27.7m	CN¥29.9m	CN¥31.7m	CN¥33.2m	CN¥34.5m	CN¥35.5m	CN¥36.4m	CN¥37.3m	CN¥38.0m	CN¥38.7m
Growth Rate Estimate Source	Est @ 10.76%	Est @ 7.98%	Est @ 6.04%	Est @ 4.68%	Est @ 3.73%	Est @ 3.06%	Est @ 2.6%	Est @ 2.27%	Est @ 2.04%	Est @ 1.88%
Present Value (CN¥, Millions) Discounted @ 9.1%	CN¥25.4	CN¥25.1	CN¥24.4	CN¥23.5	CN¥22.3	CN¥21.1	CN¥19.8	CN¥18.6	CN¥17.4	CN¥16.2

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥213m

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 9.1%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = CN¥39m× (1 + 1.5%) ÷ (9.1%– 1.5%) = CN¥520m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥520m÷ ( 1 + 9.1%)¹⁰= CN¥218m

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is CN¥431m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of HK$6.0, the company appears about fair value at a 5.2% 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.

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. 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 Wenling Zhejiang Measuring and Cutting Tools Trading Centre 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 9.1%, which is based on a levered beta of 1.209. 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.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and 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. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Wenling Zhejiang Measuring and Cutting Tools Trading Centre, we've compiled three important items you should consider:

1. Risks: We feel that you should assess the 3 warning signs for Wenling Zhejiang Measuring and Cutting Tools Trading Centre (1 shouldn't be ignored!) 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 Environmentally-Friendly Companies: Concerned about the environment and think consumers will buy eco-friendly products more and more? Browse through our interactive list of companies that are thinking about a greener future to discover some stocks you may not have thought of!

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. 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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