E-Star Commercial Management Company Limited's (HKG:6668) Intrinsic Value Is Potentially 25% Below Its Share Price

Today we will run through one way of estimating the intrinsic value of E-Star Commercial Management Company Limited (HKG:6668) by taking the expected future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. 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. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out our latest analysis for E-Star Commercial Management

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.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (CN¥, Millions)	CN¥143.1m	CN¥153.3m	CN¥161.6m	CN¥168.4m	CN¥174.2m	CN¥179.1m	CN¥183.5m	CN¥187.4m	CN¥191.0m	CN¥194.5m
Growth Rate Estimate Source	Est @ 9.51%	Est @ 7.1%	Est @ 5.41%	Est @ 4.23%	Est @ 3.41%	Est @ 2.83%	Est @ 2.42%	Est @ 2.14%	Est @ 1.94%	Est @ 1.8%
Present Value (CN¥, Millions) Discounted @ 7.3%	CN¥133	CN¥133	CN¥131	CN¥127	CN¥123	CN¥118	CN¥112	CN¥107	CN¥102	CN¥96.5

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥1.2b

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 7.3%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = CN¥194m× (1 + 1.5%) ÷ (7.3%– 1.5%) = CN¥3.4b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥3.4b÷ ( 1 + 7.3%)¹⁰= CN¥1.7b

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¥2.9b. 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$4.5, the company appears reasonably expensive at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

Important 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 E-Star Commercial Management 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 7.3%, which is based on a levered beta of 1.071. 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. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price exceeding the intrinsic value? For E-Star Commercial Management, we've compiled three essential items you should further examine:

1. Risks: You should be aware of the 1 warning sign for E-Star Commercial Management we've uncovered before considering an investment in the company.
2. Future Earnings: How does 6668'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 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. 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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