Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Yuexiu Transport Infrastructure Limited (HKG:1052) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.
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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
Is Yuexiu Transport Infrastructure fairly valued?
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. 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 discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) estimate
|Levered FCF (CN¥, Millions)||CN¥1.31b||CN¥1.23b||CN¥1.18b||CN¥1.15b||CN¥1.14b||CN¥1.13b||CN¥1.13b||CN¥1.14b||CN¥1.15b||CN¥1.16b|
|Growth Rate Estimate Source||Est @ -9.88%||Est @ -6.47%||Est @ -4.07%||Est @ -2.4%||Est @ -1.23%||Est @ -0.4%||Est @ 0.17%||Est @ 0.57%||Est @ 0.85%||Est @ 1.05%|
|Present Value (CN¥, Millions) Discounted @ 14%||CN¥1.2k||CN¥949||CN¥800||CN¥687||CN¥596||CN¥522||CN¥460||CN¥407||CN¥360||CN¥320|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥6.3b
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 14%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = CN¥1.2b× (1 + 1.5%) ÷ (14%– 1.5%) = CN¥9.6b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥9.6b÷ ( 1 + 14%)10= CN¥2.7b
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¥8.9b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of HK$4.7, the company appears a touch undervalued at a 25% 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.
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 Yuexiu Transport Infrastructure 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 14%, which is based on a levered beta of 2.000. 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.
Valuation is only one side of the coin in terms of building your investment thesis, and it 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. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Can we work out why the company is trading at a discount to intrinsic value? For Yuexiu Transport Infrastructure, we've compiled three relevant factors you should assess:
- Risks: To that end, you should learn about the 2 warning signs we've spotted with Yuexiu Transport Infrastructure (including 1 which is concerning) .
- Future Earnings: How does 1052'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. 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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