In this article, we will estimate the intrinsic value of REF Holdings Limited (HKG:1631) by taking expected future cash flows and discounting them to their present value. Our analysis will use the discounted cash flow (DCF) model. There really isn’t much to do, although it may seem quite complex.
We generally believe that the value of a company is the present value of all the cash it will generate in the future. However, a DCF is just one of many evaluation metrics, and it is not without its flaws. If you still have burning questions about this type of assessment, take a look at Simply Wall St.’s analysis template.
Check opportunities and risks within Hong Kong’s business services industry.
What is the estimated value?
We have to calculate the value of REF Holdings slightly differently than other stocks because it is a trading services company. In this approach, dividends per share (DPS) are used, because free cash flow is difficult to estimate and often not reported by analysts. Unless a company pays the majority of its FCF as a dividend, this method will generally underestimate the value of the stock. We use Gordon’s 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 10-year government bond yield of 1.6%. We then discount this figure to present value at a cost of equity of 6.8%. Against the current share price of HK$0.4, 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.
Value per share = Expected dividend per share / (Discount rate – Perpetual growth rate)
= HK$0.2 / (6.8% – 1.6%)
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 view REF 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 factors in debt. In this calculation, we used 6.8%, which is based on a leveraged beta of 0.969. 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.
Valuation is only one side of the coin in terms of crafting your investment thesis, and ideally it won’t be the only piece of analysis you look at for a company. It is not possible to obtain an infallible valuation with a DCF model. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under/overvalued?” For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on the valuation. For REF Holdings, we’ve put together three additional things you should consider:
- Risks: For example, we discovered 3 warning signs for REF Holdings (2 cannot be ignored!) that you should be aware of before investing here.
- 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 strong trading fundamentals to see if there are any other companies you may not have considered!
- Other environmentally friendly businesses: Are you concerned about the environment and do you think that consumers will buy more and more environmentally friendly products? Browse our interactive list of companies thinking about a greener future to discover actions you might not have thought of!
PS. The Simply Wall St app performs an updated cash flow assessment for each SEHK stock every day. If you want to find the calculation for other stocks, 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.