An Intrinsic Calculation For Kunlun Energy Company Limited (HKG:135) Suggests It's 43% Undervalued

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Kunlun Energy Company Limited (HKG:135) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Believe it or not, it's not too difficult to follow, as you'll see from our example!

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

View our latest analysis for Kunlun Energy

What's the estimated valuation?

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. To begin with, we have to get estimates of 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.

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

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (CN¥, Millions)	CN¥4.39b	CN¥4.84b	CN¥4.22b	CN¥4.39b	CN¥4.55b	CN¥4.52b	CN¥4.52b	CN¥4.54b	CN¥4.58b	CN¥4.62b
Growth Rate Estimate Source	Analyst x5	Analyst x5	Analyst x2	Analyst x2	Analyst x2	Est @ -0.62%	Est @ 0.01%	Est @ 0.45%	Est @ 0.76%	Est @ 0.98%
Present Value (CN¥, Millions) Discounted @ 5.4%	CN¥4.2k	CN¥4.4k	CN¥3.6k	CN¥3.6k	CN¥3.5k	CN¥3.3k	CN¥3.1k	CN¥3.0k	CN¥2.9k	CN¥2.7k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥34b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 1.5%. We discount the terminal cash flows to today's value at a cost of equity of 5.4%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = CN¥4.6b× (1 + 1.5%) ÷ (5.4%– 1.5%) = CN¥121b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥121b÷ ( 1 + 5.4%)¹⁰= CN¥72b

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¥106b. 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$8.5, the company appears quite undervalued at a 43% 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

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. 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 Kunlun Energy 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 5.4%, which is based on a levered beta of 0.800. 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:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for 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?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Why is the intrinsic value higher than the current share price? For Kunlun Energy, we've compiled three relevant aspects you should further examine:

1. Risks: For example, we've discovered 2 warning signs for Kunlun Energy (1 is potentially serious!) that you should be aware of before investing here.
2. Future Earnings: How does 135'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.