How far off is Arrail Group Limited (HKG:6639) from its intrinsic value? Using the most recent financial data, we’ll take a look at whether the stock is fairly priced by estimating the company’s future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. There’s really not all that much to it, even though it might appear quite complex.
Remember though, that there are many ways to estimate a company’s value, and a DCF is just one method. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
Is Arrail Group fairly valued?
We’re using the 2-stage growth model, which simply means we take in account two stages of company’s growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To begin with, we have to get estimates of 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.
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
|Levered FCF (CN¥, Millions)||CN¥227.1m||CN¥25.0m||CN¥65.0m||CN¥122.0m||CN¥207.0m||CN¥302.0m||CN¥355.1m||CN¥400.4m||CN¥438.0m||CN¥468.7m|
|Growth Rate Estimate Source||Est @ 24.5%||Analyst x1||Analyst x1||Analyst x1||Analyst x1||Analyst x1||Est @ 17.59%||Est @ 12.76%||Est @ 9.38%||Est @ 7.01%|
|Present Value (CN¥, Millions) Discounted @ 5.7%||CN¥215||CN¥22.4||CN¥55.0||CN¥97.6||CN¥157||CN¥216||CN¥240||CN¥256||CN¥265||CN¥269|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥1.8b
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 5-year average of the 10-year government bond yield (1.5%) 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 5.7%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = CN¥469m× (1 + 1.5%) ÷ (5.7%– 1.5%) = CN¥11b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥11b÷ ( 1 + 5.7%)10= CN¥6.4b
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¥8.2b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of HK$12.6, the company appears a touch undervalued at a 24% 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.
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 Arrail 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 5.7%, which is based on a levered beta of 0.860. 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.
Although the valuation of a company is important, it 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. 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. What is the reason for the share price sitting below the intrinsic value? For Arrail Group, we’ve put together three relevant aspects you should look at:
- Financial Health: Does 6639 have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does 6639’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
- Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. Simply Wall St updates its DCF calculation for every Hong Kong stock every day, so if you want to find the intrinsic value of any other stock just search here.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.