Does Vertical International Holdings Limited (HKG:8375) share price in February reflect what it is really worth? Today we are going to estimate the intrinsic value of the stock by taking the expected future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Believe it or not, it’s not too hard to follow, as you’ll see in our example!
We draw your attention to the fact that there are many ways to value a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you want to know more about discounted cash flow, the rationale for this calculation can be read in detail in the Simply Wall St analysis template.
Check out our latest analysis for Vertical International Holdings
Is Vertical International Holdings valued at its fair value?
We use what is called a 2-stage model, which simply means that we have two different periods of company cash flow growth rates. Generally, the first stage is a higher growth phase and the second stage is a lower growth phase. To start, we need to estimate the cash flows for the next ten years. Since no analyst estimates of free cash flow are available to us, we have extrapolated the previous free cash flow (FCF) from the company’s latest reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we discount the value of these future cash flows to their estimated value in today’s dollars:
10-Year Free Cash Flow (FCF) Forecast
|Leveraged FCF (HK$, Millions)||HK$2.25 million||HK$2.42 million||HK$2.55 million||HK$2.66 million||HK$2.75 million||HK$2.83 million||HK$2.90 million||HK$2.96 million||HK$3.02 million||HK$3.08 million|
|Growth rate estimate Source||Is at 9.77%||Is at 7.28%||Is at 5.54%||Is at 4.32%||Is at 3.47%||Is at 2.87%||Is at 2.45%||Is at 2.16%||Is 1.96%||Is at 1.81%|
|Present value (HK$, millions) discounted at 7.9%||HK$2.1||HK$2.1||HK$2.0||HK$2.0||HK$1.9||HK$1.8||HK$1.7||HK$1.6||HK$1.5||HK$1.4|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = HK$18 million
The second stage is also known as the terminal value, it is the cash flow of the business after the first stage. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 1.5%. We discount the terminal cash flows to their present value at a cost of equity of 7.9%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = HK$3.1 million × (1 + 1.5%) ÷ (7.9%–1.5%) = HK$49 million Kong
Present value of terminal value (PVTV)= TV / (1 + r)ten= HK$49 million ÷ (1 + 7.9%)ten= HK$23 million
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is HK$41 million. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Against the current share price of HK$0.2, the company appears around fair value at the time of writing. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.
The above calculation is highly dependent on two assumptions. One is the discount rate and the other is the cash flows. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play around with them. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Vertical International 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 takes debt into account. In this calculation, we used 7.9%, which is based on a leveraged beta of 1.310. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Let’s move on :
Although a business valuation is important, it is only one of many factors you need to assess for a business. The DCF model is not a perfect stock valuation tool. Rather, it should be seen as a guide to “what assumptions must 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, output may be very different. For Vertical International Holdings, we’ve rounded up three more things you should explore:
- Risks: For example, we discovered 5 warning signs for Vertical International Holdings (2 are a little nasty!) that you should be aware of before investing here.
- Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of what you might be missing!
- Other top analyst picks: Interested to see what the analysts think? Take a look at our interactive list of analysts’ top stock picks to find out what they think could have attractive future prospects!
PS. Simply Wall St updates its DCF calculation for every Hong Kong stock daily, so if you want to find the intrinsic value of any other stock, just search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.