Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Boyaa Interactive International Limited (HKG:434) as an investment opportunity by taking the expected future cash flows and discounting them 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.
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
2020
2021
2022
2023
2024
2025
2026
2027
2028
2029
Levered FCF (CN¥, Millions)
CN¥65.3m
CN¥53.1m
CN¥46.5m
CN¥42.7m
CN¥40.5m
CN¥39.3m
CN¥38.8m
CN¥38.6m
CN¥38.7m
CN¥39.0m
Growth Rate Estimate Source
Est @ -27.56%
Est @ -18.69%
Est @ -12.48%
Est @ -8.14%
Est @ -5.09%
Est @ -2.97%
Est @ -1.47%
Est @ -0.43%
Est @ 0.3%
Est @ 0.81%
Present Value (CN¥, Millions) Discounted @ 7.61%
CN¥60.7
CN¥45.9
CN¥37.3
CN¥31.9
CN¥28.1
CN¥25.3
CN¥23.2
CN¥21.5
CN¥20.0
CN¥18.7
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF)= CN¥312.6m
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 10-year government bond rate (2%) 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 7.6%.
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = CN¥CN¥710m ÷ ( 1 + 7.6%)10 = CN¥341.01m
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 CN¥653.59m. The last step is to then divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate in the company’s reported currency of CN¥0.99. However, 434’s primary listing is in China, and 1 share of 434 in CNY represents 1.137 ( CNY/ HKD) share of SEHK:434, so the intrinsic value per share in HKD is HK$1.12. Relative to the current share price of HK$1.33, 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:434 Intrinsic value, August 1st 2019
The assumptions
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Boyaa Interactive 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 accounts for debt. In this calculation we've used 7.6%, which is based on a levered beta of 0.941. 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 Boyaa Interactive International, I've compiled three important factors you should further research:
Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of 434? 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.
