Calculating The Fair Value Of Optima Automobile Group Holdings Limited (HKG:8418)

Does the April share price for Optima Automobile Group Holdings Limited (HKG:8418) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by estimating the company's future cash flows and discounting them to their present 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 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 still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

View our latest analysis for Optima Automobile Group Holdings

Step by step through the calculation

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. 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, 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) forecast

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (SGD, Millions)	S$4.66m	S$7.57m	S$10.9m	S$14.3m	S$17.6m	S$20.4m	S$22.8m	S$24.8m	S$26.4m	S$27.7m
Growth Rate Estimate Source	Est @ 88.67%	Est @ 62.52%	Est @ 44.22%	Est @ 31.41%	Est @ 22.44%	Est @ 16.16%	Est @ 11.76%	Est @ 8.69%	Est @ 6.53%	Est @ 5.03%
Present Value (SGD, Millions) Discounted @ 7.8%	S$4.3	S$6.5	S$8.7	S$10.6	S$12.1	S$13.0	S$13.5	S$13.6	S$13.4	S$13.1

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = S$108m

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 7.8%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = S$28m× (1 + 1.5%) ÷ (7.8%– 1.5%) = S$448m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= S$448m÷ ( 1 + 7.8%)¹⁰= S$212m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is S$320m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of HK$1.8, the company appears about fair value at a 19% 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

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 Optima Automobile Group 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 7.8%, which is based on a levered beta of 1.201. 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:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/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 Optima Automobile Group Holdings, we've put together three additional aspects you should explore:

1. Risks: Be aware that Optima Automobile Group Holdings is showing 2 warning signs in our investment analysis , and 1 of those is a bit unpleasant...
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 Top Analyst Picks: Interested to see what the analysts are thinking? Take a look at our interactive list of analysts' top stock picks to find out what they feel might have an attractive future outlook!

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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