Does the April share price for King Fook Holdings Limited (HKG:280) reflect what it’s really worth? Today, we will estimate the stock’s intrinsic value by taking the foreast future cash flows of the company and discounting them back to today’s value. I will use the Discounted Cash Flow (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward.
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
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. 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.
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
|Levered FCF (HK$, Millions)||HK$32.8m||HK$24.4m||HK$20.1m||HK$17.7m||HK$16.4m||HK$15.5m||HK$15.1m||HK$14.8m||HK$14.7m||HK$14.7m|
|Growth Rate Estimate Source||Est @ -37.35%||Est @ -25.68%||Est @ -17.51%||Est @ -11.79%||Est @ -7.79%||Est @ -4.99%||Est @ -3.03%||Est @ -1.65%||Est @ -0.69%||Est @ -0.02%|
|Present Value (HK$, Millions) Discounted @ 8.2%||HK$30.3||HK$20.8||HK$15.9||HK$12.9||HK$11.0||HK$9.7||HK$8.7||HK$7.9||HK$7.2||HK$6.7|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = HK$131m
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 10-year government bond rate of 1.6%. We discount the terminal cash flows to today’s value at a cost of equity of 8.2%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = HK$15m× (1 + 1.6%) ÷ 8.2%– 1.6%) = HK$224m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= HK$224m÷ ( 1 + 8.2%)10= HK$102m
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$233m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of HK$0.2, the company appears about fair value at a 5.1% 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.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. Part of investing is coming up with your own evaluation of a company’s future performance, so try the calculation yourself and check your own 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 King Fook Holdings 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 8.2%, which is based on a levered beta of 1.097. 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.
Whilst important, 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. 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 King Fook Holdings, We’ve put together three important aspects you should further examine:
- Risks: You should be aware of the 2 warning signs for King Fook Holdings we’ve uncovered before considering an investment in the company.
- Other Solid Businesses: 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 business fundamentals to see if there are other companies you may not have considered!
- Other Top Analyst Picks: Interested to see what the analysts are thinking? Take a look at our interactive list of analysts’ top stock picks to find out what they feel might have an attractive future outlook!
PS. Simply Wall St updates its DCF calculation for every HK stock every day, so if you want to find the intrinsic value of any other stock just search here.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned.
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