Stock Analysis

Calculating The Intrinsic Value Of Air China Limited (HKG:753)

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SEHK:753
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In this article we are going to estimate the intrinsic value of Air China Limited (HKG:753) by taking the expected future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. There's really not all that much to it, even though it might appear quite complex.

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 Air China

Crunching the numbers

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 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, 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

2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
Levered FCF (CN¥, Millions) CN¥9.39b CN¥15.9b CN¥13.2b CN¥10.8b CN¥9.48b CN¥8.70b CN¥8.24b CN¥7.98b CN¥7.84b CN¥7.78b
Growth Rate Estimate Source Analyst x6 Analyst x6 Analyst x2 Analyst x1 Est @ -12.42% Est @ -8.2% Est @ -5.25% Est @ -3.18% Est @ -1.74% Est @ -0.72%
Present Value (CN¥, Millions) Discounted @ 13% CN¥8.3k CN¥12.5k CN¥9.3k CN¥6.7k CN¥5.2k CN¥4.3k CN¥3.6k CN¥3.1k CN¥2.7k CN¥2.4k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥58b

The second stage is also known as Terminal Value, this is the business's cash flow after 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 (1.6%) 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 13%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = CN¥7.8b× (1 + 1.6%) ÷ (13%– 1.6%) = CN¥72b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥72b÷ ( 1 + 13%)10= CN¥22b

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¥80b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of HK$6.3, the company appears about fair value at a 2.5% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

dcf
SEHK:753 Discounted Cash Flow November 25th 2020

Important assumptions

Now 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 Air China 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 13%, which is based on a levered beta of 1.500. 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.

Moving On:

Although the valuation of a company is important, it 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 Air China, there are three additional items you should explore:

  1. Risks: Case in point, we've spotted 1 warning sign for Air China you should be aware of.
  2. Future Earnings: How does 753'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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