Estimating The Intrinsic Value Of China Technology Industry Group Limited (HKG:8111)

In this article we are going to estimate the intrinsic value of China Technology Industry Group Limited (HKG:8111) by taking the expected future cash flows and discounting them to their present value. This will be done using 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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for China Technology Industry Group

The model

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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (CN¥, Millions)	CN¥6.80m	CN¥7.12m	CN¥7.39m	CN¥7.62m	CN¥7.81m	CN¥7.99m	CN¥8.15m	CN¥8.31m	CN¥8.45m	CN¥8.59m
Growth Rate Estimate Source	Est @ 6.17%	Est @ 4.76%	Est @ 3.78%	Est @ 3.09%	Est @ 2.61%	Est @ 2.27%	Est @ 2.03%	Est @ 1.87%	Est @ 1.75%	Est @ 1.67%
Present Value (CN¥, Millions) Discounted @ 9.2%	CN¥6.2	CN¥6.0	CN¥5.7	CN¥5.3	CN¥5.0	CN¥4.7	CN¥4.4	CN¥4.1	CN¥3.8	CN¥3.6

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥48m

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. 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 9.2%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = CN¥8.6m× (1 + 1.5%) ÷ (9.2%– 1.5%) = CN¥112m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥112m÷ ( 1 + 9.2%)¹⁰= CN¥46m

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¥94m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of HK$0.3, the company appears around fair value 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.

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 China Technology Industry 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 9.2%, which is based on a levered beta of 1.462. 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 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. 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 China Technology Industry Group, there are three additional aspects you should explore:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with China Technology Industry Group (at least 1 which is concerning) , and understanding these should be part of your investment process.
2. 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!
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. Simply Wall St updates its DCF calculation for every Hong Kong stock every day, so if you want to find the intrinsic value of any other stock 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.
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