Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Alibaba Health Information Technology Limited (HKG:241) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!
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.
Step by step through the calculation
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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.
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
|Levered FCF (CN¥, Millions)||CN¥9.75m||CN¥269.4m||CN¥787.3m||CN¥1.57b||CN¥1.78b||CN¥2.70b||CN¥3.37b||CN¥3.97b||CN¥4.49b||CN¥4.91b|
|Growth Rate Estimate Source||Analyst x4||Analyst x5||Analyst x6||Analyst x4||Analyst x2||Analyst x2||Est @ 24.83%||Est @ 17.82%||Est @ 12.92%||Est @ 9.49%|
|Present Value (CN¥, Millions) Discounted @ 6.5%||CN¥9.2||CN¥238||CN¥652||CN¥1.2k||CN¥1.3k||CN¥1.9k||CN¥2.2k||CN¥2.4k||CN¥2.6k||CN¥2.6k|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥15b
After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 6.5%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = CN¥4.9b× (1 + 1.5%) ÷ (6.5%– 1.5%) = CN¥100b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥100b÷ ( 1 + 6.5%)10= CN¥53b
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¥68b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of HK$4.8, the company appears about fair value at a 19% discount to where the stock price trades currently. 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.
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 Alibaba Health Information Technology 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 6.5%, which is based on a levered beta of 1.032. 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.
Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. 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. For Alibaba Health Information Technology, there are three essential items you should look at:
- Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Alibaba Health Information Technology , and understanding it should be part of your investment process.
- Future Earnings: How does 241'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 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. 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.