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Today we'll do a simple run through of a valuation method used to estimate the attractiveness of United Energy Group Limited (HKG:467) as an investment opportunity by taking the foreast future cash flows of the company and discounting them back to today's value. I will be using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. 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 begin with, we have to get estimates of 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.
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) estimate
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
Levered FCF (HK$, Millions)
HK$2.1b
HK$2.3b
HK$2.4b
HK$2.4b
HK$2.5b
HK$2.6b
HK$2.7b
HK$2.7b
HK$2.8b
HK$2.8b
Growth Rate Estimate Source
Est @ 6.76%
Est @ 5.33%
Est @ 4.34%
Est @ 3.64%
Est @ 3.15%
Est @ 2.8%
Est @ 2.56%
Est @ 2.39%
Est @ 2.28%
Est @ 2.2%
Present Value (HK$, Millions) Discounted @ 8.37%
HK$2.0k
HK$1.9k
HK$1.9k
HK$1.8k
HK$1.7k
HK$1.6k
HK$1.5k
HK$1.4k
HK$1.3k
HK$1.3k
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF)= HK$16.4b
After calculating the present value of future cash flows in the intial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 10-year government bond rate of 2%. We discount the terminal cash flows to today's value at a cost of equity of 8.4%.
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = HK$HK$46b ÷ ( 1 + 8.4%)10 = HK$20.39b
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is HK$36.76b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. This results in an intrinsic value estimate of HK$1.4. Relative to the current share price of HK$1.49, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
SEHK:467 Intrinsic value, July 10th 2019
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 United Energy Group 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 8.4%, which is based on a levered beta of 0.957. 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.
Next Steps:
Valuation is only one side of the coin in terms of building your investment thesis, and 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 United Energy Group, I've compiled three essential factors you should further research:
Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of 467? 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 HKG every day. If you want to find the calculation for other stocks just search here.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Thank you for reading.
