In this article we are going to estimate the intrinsic value of China Shenhua Energy Company Limited (HKG:1088) by taking the expected future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or 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:
2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | 2033 | 2034 | |
Levered FCF (CN¥, Millions) | CN¥60.4b | CN¥60.4b | CN¥60.9b | CN¥61.6b | CN¥62.6b | CN¥63.8b | CN¥65.1b | CN¥66.5b | CN¥68.0b | CN¥69.5b |
Growth Rate Estimate Source | Analyst x3 | Analyst x3 | Est @ 0.76% | Est @ 1.26% | Est @ 1.62% | Est @ 1.86% | Est @ 2.04% | Est @ 2.16% | Est @ 2.24% | Est @ 2.30% |
Present Value (CN¥, Millions) Discounted @ 7.9% | CN¥55.9k | CN¥51.9k | CN¥48.4k | CN¥45.4k | CN¥42.8k | CN¥40.4k | CN¥38.2k | CN¥36.1k | CN¥34.2k | CN¥32.5k |
("Est" = FCF growth rate estimated by Simply Wall St)Present Value of 10-year Cash Flow (PVCF) = CN¥426b
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 5-year average of the 10-year government bond yield of 2.4%. We discount the terminal cash flows to today's value at a cost of equity of 7.9%.
Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = CN¥70b× (1 + 2.4%) ÷ (7.9%– 2.4%) = CN¥1.3t
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥1.3t÷ ( 1 + 7.9%)10= CN¥607b
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¥1.0t. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of HK$32.3, the company appears quite good value at a 42% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
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 Shenhua Energy 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 7.9%, which is based on a levered beta of 1.039. 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.
Check out our latest analysis for China Shenhua Energy
Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For China Shenhua Energy, there are three important items you should explore:
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the SEHK every day. If you want to find the calculation for other stocks just search here.
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