Today we are going to walk through a way to estimate the intrinsic value of Haidilao International Holding Ltd. (HKG:6862) by taking expected future cash flows and discounting them to the present value. One way to do this is to use the discounted cash flow (DCF) model. Believe it or not, it’s not too hard to follow, as you’ll see in our example!
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 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.
See our latest analysis for Haidilao International Holding
The calculation
We use the 2-stage growth model, which simply means that we consider two stages of business growth. In the initial period, the company may have a higher growth rate, and the second stage is generally assumed to have a stable growth rate. In the first step, we need to estimate the company’s cash flow over 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.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, and so the sum of these future cash flows is then discounted to today’s value:
10-Year Free Cash Flow (FCF) Forecast
2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | |
Leveraged FCF (CN¥, Million) | CN¥4.53b | CN¥5.91b | CN¥6.94b | CN¥7.82b | CN¥8.55b | CN¥9.14b | CN¥9.63b | CN¥10.0b | CN¥10.4b | CN¥10.7b |
Growth rate estimate Source | Analyst x6 | Analyst x6 | Is at 17.46% | Is at 12.67% | Is at 9.31% | Is at 6.96% | Is at 5.32% | Is at 4.17% | Is at 3.36% | East @ 2.8% |
Present value (CN¥, million) discounted at 7.3% | CN¥4.2k | CN¥5.1k | CN¥5.6k | CN¥5.9k | CN¥6.0k | CN¥6.0k | CN¥5.9k | CN¥5.7k | CN¥5.5k | CN¥5.3k |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = CN¥55b
We now need to calculate the terminal value, which represents all future cash flows after this ten-year period. 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 terminal cash flows to present value at a cost of equity of 7.3%.
Terminal value (TV)= FCF_{2031} × (1 + g) ÷ (r – g) = CN¥11b × (1 + 1.5%) ÷ (7.3%–1.5%) = CN¥185b
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= CN¥185b÷ ( 1 + 7.3%)^{ten}= CN¥91b
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is 146 billion yen. The final step is to divide the equity value by the number of shares outstanding. Compared to the current share price of HK$20.2, the company appears to be pretty good value with a 37% discount to the current share price. The assumptions of any calculation have a big impact on the valuation, so it’s best to consider this as a rough estimate, not accurate down to the last penny.
Important assumptions
Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flows. Part of investing is coming up with 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 consider Haidilao International Holding 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 7.3%, which is based on a leveraged beta of 1.185. 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 important, the DCF calculation is just one of many factors you need to assess for a business. It is not possible to obtain an infallible valuation with a DCF model. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on the valuation. Why is the stock price below intrinsic value? For Haidilao International Holding, we have compiled three relevant items for you to assess:
- Risks: Know that Haidilao International Holding shows 3 warning signs in our investment analysis and 1 of them does not suit us too much…
- Future earnings: How does the growth rate of 6862 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 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!
PS. The Simply Wall St app performs an updated cash flow valuation 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.