Today we will run through one way of estimating the intrinsic value of China ITS (Holdings) Co., Ltd. (HKG:1900) by estimating the company's future cash flows and discounting them to their present value. I will be using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
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.
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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, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
2019
2020
2021
2022
2023
2024
2025
2026
2027
2028
Levered FCF (CN¥, Millions)
CN¥10.40
CN¥16.79
CN¥24.13
CN¥31.65
CN¥38.74
CN¥45.05
CN¥50.46
CN¥55.01
CN¥58.81
CN¥62.00
Growth Rate Estimate Source
Est @ 87.03%
Est @ 61.52%
Est @ 43.67%
Est @ 31.17%
Est @ 22.42%
Est @ 16.29%
Est @ 12.01%
Est @ 9.01%
Est @ 6.9%
Est @ 5.43%
Present Value (CN¥, Millions) Discounted @ 13.92%
CN¥9.13
CN¥12.94
CN¥16.32
CN¥18.79
CN¥20.19
CN¥20.61
CN¥20.26
CN¥19.39
CN¥18.19
CN¥16.84
Present Value of 10-year Cash Flow (PVCF)= CN¥172.66m
"Est" = FCF growth rate estimated by Simply Wall St
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 13.9%.
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = CN¥CN¥531m ÷ ( 1 + 13.9%)10 = CN¥144.09m
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¥316.74m. In the final step we 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¥0.19. However, 1900’s primary listing is in China, and 1 share of 1900 in CNY represents 1.142 ( CNY/ HKD) share of SEHK:1900, so the intrinsic value per share in HKD is HK$0.22. Relative to the current share price of HK$0.23, 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:1900 Intrinsic value, May 17th 2019
Important assumptions
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 China ITS (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 13.9%, which is based on a levered beta of 2. 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:
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 China ITS (Holdings), I've compiled three further factors you should further examine:
Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of 1900? 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.
