Today we are going to walk through one way to estimate the intrinsic value of Home Control International Limited (HKG:1747) by estimating the future cash flows of the business and discounting them to their present value. One way to do this is to use the discounted cash flow (DCF) model. Don’t be put off by the jargon, the underlying calculations are actually quite simple.
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. Anyone interested in learning a little more about intrinsic value should read the Simply Wall St.
See our latest analysis for Home Control International
What is the estimated valuation?
We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “sustained growth”. To begin with, we need to obtain cash flow estimates for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or 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.
Generally, we assume that a dollar today is worth more than a dollar in the future, and so the sum of these future cash flows is then discounted to today’s value:
10-Year Free Cash Flow (FCF) Forecast
|Leveraged FCF ($, millions)||-$200,000||$5.50 million||$4.50 million||$3.94 million||$3.62 million||$3.43 million||$3.31 million||$3.25 million||$3.23 million||$3.22 million|
|Growth rate estimate Source||Analyst x1||Analyst x1||Is @ -18.27%||East @ -12.34%||Is @ -8.2%||East @ -5.29%||Is @ -3.26%||Is @ -1.84%||Is @ -0.84%||Is @ -0.15%|
|Present value (millions of dollars) discounted at 7.9%||-0.2 USD||$4.7||$3.6||$2.9||$2.5||$2.2||$1.9||$1.8||$1.6||$1.5|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $22 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) = $3.2 million × (1 + 1.5%) ÷ (7.9%–1.5%) = $51 million
Present value of terminal value (PVTV)= TV / (1 + r)ten= $51m ÷ (1 + 7.9%)ten= $24 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 $46 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$0.7, 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. If you disagree with these results, try the math yourself and play around with the 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 consider Home Control International 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 1.521. 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.
While important, calculating DCF shouldn’t be the only metric to consider when researching 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 Home Control International, we have compiled three important factors to consider:
- Risks: For example, we spotted 3 warning signs for Home Control International you should know, and one of them makes us a little uneasy.
- Future earnings: How does 1747’s growth rate compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years 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 strong trading fundamentals to see if there are any other companies you may not have considered!
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.