Today we’re going to review one way to estimate the intrinsic value of China Everbright Water Limited (SGX: U9E) by taking expected future cash flows and discounting them to present value. One way to do this is to use the Discounted Cash Flow (DCF) model. Don’t be put off by the lingo, the math is actually pretty straightforward.
We would like to point out that there are many ways to assess a business and, like DCF, each technique has advantages and disadvantages in certain scenarios. For those who are thoroughly learning equity analysis, the Simply Wall St analysis template here may interest you.
Check out our latest analysis for China Everbright Water
Is China Everbright Water valued enough?
As China Everbright Water operates in the water service business, we have to calculate intrinsic value slightly differently. Instead of using free cash flow, which is difficult to estimate and often unreported by industry analysts, dividend payments per share (DPS) are used. This often underestimates the value of a stock, but it can still be good in comparison to the competition. We use the Gordon Growth Model, which assumes that the dividend will grow in perpetuity at a rate that can be sustained. The dividend is expected to grow at an annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.0%. We then discount this figure to present value at a cost of equity of 7.0%. Compared to the current share price of S $ 0.3, the company appears to be quite undervalued with a 35% discount from the current share price. The assumptions in any calculation have a big impact on the valuation, so it’s best to think of this as a rough estimate, not precise down to the last penny.
Value per share = expected dividend per share / (discount rate – perpetual growth rate)
= 0.1 HK $ / (7.0% – 2.0%)
= S $ 0.4
The above calculation is very dependent on two assumptions. One is the discount rate and the other is cash flow. Part of investing is making your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. 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 view China Everbright Water 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 into account debt. In this calculation, we used 7.0%, which is based on a leverage beta of 0.800. Beta is a measure of the volatility of a stock, relative 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.
While important, the DCF calculation is just one of the many factors you need to assess for a business. It is not possible to obtain an infallible valuation with a DCF model. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. What is the reason why the stock price is lower than intrinsic value? For China Everbright Water, you need to consider three essential elements:
- Risks: Every company has them, and we have spotted 2 warning signs for China Everbright Water (of which 1 should not be ignored!) that you should know.
- Future income: How does U9E’s growth rate compare to its peers and to the market in general? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth forecast chart.
- Other strong companies: Low debt, high returns on equity, and good past performance are essential to a strong business. Why not explore our interactive list of stocks with solid trading fundamentals to see if there are other companies you may not have considered!
PS. Simply Wall St updates its DCF calculation for every Singaporean stock every day, so if you want to find the intrinsic value of any other stock just search here.
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