Does the January share price for Jiangxi Copper Company Limited (HKG:358) reflect what it’s really worth? Today, we will estimate the stock’s intrinsic value by projecting its future cash flows and then discounting them to today’s value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Don’t get put off by the jargon, the math behind it is actually quite straightforward.
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 want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. In the first stage we need to estimate the cash flows to the business over the next ten years. 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, and so the sum of these future cash flows is then discounted to today’s value:
10-year free cash flow (FCF) estimate
|Levered FCF (CN¥, Millions)||CN¥7.02b||CN¥6.74b||CN¥6.60b||CN¥6.53b||CN¥6.52b||CN¥6.53b||CN¥6.57b||CN¥6.63b||CN¥6.70b||CN¥6.78b|
|Growth Rate Estimate Source||Analyst x1||Analyst x1||Est @ -2.1%||Est @ -1.03%||Est @ -0.28%||Est @ 0.25%||Est @ 0.62%||Est @ 0.88%||Est @ 1.06%||Est @ 1.18%|
|Present Value (CN¥, Millions) Discounted @ 9.7%||CN¥6.4k||CN¥5.6k||CN¥5.0k||CN¥4.5k||CN¥4.1k||CN¥3.7k||CN¥3.4k||CN¥3.2k||CN¥2.9k||CN¥2.7k|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥42b
The second stage is also known as Terminal Value, this is the business’s cash flow after 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 1.5%. We discount the terminal cash flows to today’s value at a cost of equity of 9.7%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = CN¥6.8b× (1 + 1.5%) ÷ (9.7%– 1.5%) = CN¥84b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥84b÷ ( 1 + 9.7%)10= CN¥33b
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is CN¥75b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of HK$13.5, the company appears quite good value at a 49% 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.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don’t have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Jiangxi Copper 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 9.7%, which is based on a levered beta of 1.656. 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. It’s not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to “what assumptions need to be true for this stock to be under/overvalued?” For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Why is the intrinsic value higher than the current share price? For Jiangxi Copper, there are three relevant items you should look at:
- Risks: Case in point, we’ve spotted 2 warning signs for Jiangxi Copper you should be aware of, and 1 of them is potentially serious.
- Future Earnings: How does 358’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. Simply Wall St updates its DCF calculation for every Hong Kong stock every day, so if you want to find the intrinsic value of any other stock 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.