Estimating The Fair Value Of Cathay Pacific Airways Limited (HKG:293)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Cathay Pacific Airways fair value estimate is HK$9.31
• With HK$7.78 share price, Cathay Pacific Airways appears to be trading close to its estimated fair value
• The HK$10.79 analyst price target for 293 is 16% more than our estimate of fair value

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Cathay Pacific Airways Limited (HKG:293) 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. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

See our latest analysis for Cathay Pacific Airways

Step By Step Through The Calculation

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (HK$, Millions)	HK$10.2b	HK$9.60b	HK$3.17b	HK$6.73b	HK$5.71b	HK$5.14b	HK$4.81b	HK$4.62b	HK$4.52b	HK$4.48b
Growth Rate Estimate Source	Analyst x4	Analyst x4	Analyst x1	Analyst x1	Est @ -15.19%	Est @ -10.04%	Est @ -6.44%	Est @ -3.91%	Est @ -2.15%	Est @ -0.91%
Present Value (HK$, Millions) Discounted @ 10%	HK$9.2k	HK$7.9k	HK$2.4k	HK$4.6k	HK$3.5k	HK$2.9k	HK$2.4k	HK$2.1k	HK$1.9k	HK$1.7k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = HK$39b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 10%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = HK$4.5b× (1 + 2.0%) ÷ (10%– 2.0%) = HK$56b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= HK$56b÷ ( 1 + 10%)¹⁰= HK$21b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is HK$60b. 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$7.8, the company appears about fair value at a 16% 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.

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Cathay Pacific Airways 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 10%, which is based on a levered beta of 1.383. 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.

SWOT Analysis for Cathay Pacific Airways

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. 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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Cathay Pacific Airways, we've put together three important factors you should consider:

1. Risks: For example, we've discovered 1 warning sign for Cathay Pacific Airways that you should be aware of before investing here.
2. Future Earnings: How does 293'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.
3. 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.