Calculating The Fair Value Of HengTen Networks Group Limited (HKG:136)

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of HengTen Networks Group Limited (HKG:136) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

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 want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

See our latest analysis for HengTen Networks Group

Crunching the numbers

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 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, 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

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (CN¥, Millions)	-CN¥239.0m	CN¥345.0m	CN¥998.0m	CN¥1.63b	CN¥2.35b	CN¥3.10b	CN¥3.80b	CN¥4.42b	CN¥4.94b	CN¥5.37b
Growth Rate Estimate Source	Analyst x1	Analyst x1	Analyst x1	Est @ 63.11%	Est @ 44.62%	Est @ 31.68%	Est @ 22.62%	Est @ 16.28%	Est @ 11.84%	Est @ 8.73%
Present Value (CN¥, Millions) Discounted @ 6.9%	-CN¥224	CN¥302	CN¥816	CN¥1.2k	CN¥1.7k	CN¥2.1k	CN¥2.4k	CN¥2.6k	CN¥2.7k	CN¥2.7k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥16b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (1.5%) 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 6.9%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = CN¥5.4b× (1 + 1.5%) ÷ (6.9%– 1.5%) = CN¥100b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥100b÷ ( 1 + 6.9%)¹⁰= CN¥51b

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¥67b. 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$8.8, the company appears about fair value at a 0.02% 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

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 HengTen Networks Group 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 6.9%, which is based on a levered beta of 1.027. 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:

Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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 HengTen Networks Group, we've compiled three important elements you should explore:

1. Risks: To that end, you should be aware of the 4 warning signs we've spotted with HengTen Networks Group .
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for 136's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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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