How far is Huadian Power International Corporation Limited (HKG: 1071) from its intrinsic value? Using the most recent financial data, we’ll examine whether the stock price is fair by estimating the company’s future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. It may sound complicated, but it’s actually quite simple!
There are many ways that businesses can be assessed, so we would like to point out that a DCF is not perfect for all situations. If you still have burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
Check out our latest analysis for Huadian Power International
We are going to use a two-step DCF model, which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “steady growth”. To begin with, we need to estimate the next ten years of cash flow. Since no free cash flow analyst estimate is available, we have extrapolated the previous free cash flow (FCF) from the last reported value of the company. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we discount the value of those future cash flows to their estimated value in today’s dollars. hui:
10-year Free Cash Flow (FCF) estimate
|Leverage FCF (CN ¥, Million)||CN ¥ 2.31b||CN ¥ 2.15b||CN ¥ 2.05b||CN ¥ 2.00b||CN ¥ 1.97b||CN ¥ 1.96b||CN ¥ 1.96b||CN ¥ 1.97b||CN ¥ 1.98b||CN ¥ 2.00b|
|Source of estimated growth rate||Is @ -10.57%||Is @ -6.96%||Is @ -4.43%||East @ -2.65%||Is @ -1.41%||East @ -0.55%||Is @ 0.06%||Is @ 0.49%||Is @ 0.79%||East @ 0.99%|
|Present value (CN ¥, Million) discounted at 6.7%||CN ¥ 2.2k||CN ¥ 1.9k||CN ¥ 1.7k||CN ¥ 1.5k||CN ¥ 1.4k||CN ¥ 1.3k||CN ¥ 1.2k||CN ¥ 1.2k||CN ¥ 1.1k||CN ¥ 1.0k|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = CN ¥ 15b
After calculating the present value of future cash flows over the initial 10 year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first step. The Gordon growth formula is used to calculate the 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 their present value at a cost of equity of 6.7%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = CN ¥ 2.0b × (1 + 1.5%) ÷ (6.7% – 1.5%) = CN ¥ 39b
Present value of terminal value (PVTV)= TV / (1 + r)ten= CN ¥ 39b ÷ (1 + 6.7%)ten= CN ¥ 20b
Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is CN ¥ 35b. The last step is then to divide the equity value by the number of shares outstanding. Compared to the current share price of HK $ 3.2, the company appears to be slightly undervalued with a 24% discount from the current share price. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.
The above calculation is very dependent on two assumptions. One is the discount rate and the other is the cash flow. Part of investing is coming up with your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a full picture of a company’s potential performance. Since we consider Huadian Power International 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 takes into account debt. . In this calculation, we used 6.7%, which is based on a leveraged beta of 1.053. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our beta from the industry average beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
While important, calculating DCF is just one of the many factors you need to assess for a business. DCF models are not the ultimate solution for investment valuation. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. Why is intrinsic value greater than the current share price? For Huadian Power International, there are three relevant elements that you should research further:
- Risks: Note that Huadian Power International shows 5 warning signs in our investment analysis , and 1 of them cannot be ignored …
- Future benefits: How does 1071’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth expectations chart.
- Other strong companies: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid trading fundamentals to see if there are other companies you may not have considered!
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.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only 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 into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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