In this article we are going to estimate the intrinsic value of China Railway Group Limited (SHSE:601390) by taking the forecast future cash flows of the company and discounting them back to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. There's really not all that much to it, even though it might appear quite complex.
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
View our latest analysis for China Railway Group
We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To begin with, we have to get estimates of the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) estimate
|Levered FCF (CN¥, Millions)||CN¥13.2b||CN¥18.6b||CN¥22.9b||CN¥26.7b||CN¥30.2b||CN¥33.2b||CN¥35.8b||CN¥38.2b||CN¥40.3b||CN¥42.3b|
|Growth Rate Estimate Source||Analyst x3||Analyst x2||Est @ 22.89%||Est @ 17%||Est @ 12.87%||Est @ 9.98%||Est @ 7.96%||Est @ 6.54%||Est @ 5.55%||Est @ 4.86%|
|Present Value (CN¥, Millions) Discounted @ 13%||CN¥11.7k||CN¥14.5k||CN¥15.8k||CN¥16.3k||CN¥16.3k||CN¥15.8k||CN¥15.1k||CN¥14.2k||CN¥13.3k||CN¥12.3k|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥145b
After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 3.2%. We discount the terminal cash flows to today's value at a cost of equity of 13%.
Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = CN¥42b× (1 + 3.2%) ÷ (13%– 3.2%) = CN¥442b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥442b÷ ( 1 + 13%)10= CN¥129b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is CN¥274b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of CN¥6.5, the company appears quite good value at a 42% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.SHSE:601390 Discounted Cash Flow July 20th 2022
We would point out that 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 evaluation of a company's future performance, so try the calculation yourself and check your own assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at China Railway Group 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 accounts for debt. In this calculation we've used 13%, which is based on a levered beta of 2.000. Beta is a measure of a stock's volatility, compared 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.
Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Can we work out why the company is trading at a discount to intrinsic value? For China Railway Group, we've put together three relevant aspects you should explore:
- Risks: As an example, we've found 2 warning signs for China Railway Group (1 is a bit unpleasant!) that you need to consider before investing here.
- Future Earnings : How does 601390's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
- Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the SHSE every day. If you want to find the calculation for other stocks just search here.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.