Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Fu Shou Yuan International Group Limited (

HKG:1448

) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. This why do earrings make my ears itchis done using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

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

.

See our latest analysis for Fu Shou Yuan International Group

The method

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. To start off with, we need to estimate the next ten years of cash flows. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

2020

2021

2022

2023

2024

2025

2026

2027

2028

2029

Levered FCF (CN¥, Millions)

CN¥701.9m

CN¥766.2m

CN¥819.9m

CN¥865.1m

CN¥903.6m

CN¥937.3m

CN¥967.3m

CN¥994.8m

CN¥1.02b

CN¥1.05b

Growth Rate Estimate Source

Est @ 12.23%

Est @ 9.16%

Est @ 7.01%

Est @ 5.51%

Est @ 4.46%

Est @ 3.72%

Est @ 3.21%

Est @ 2.85%

Est @ 2.59%

Est @ 2.42%

Present Value (CN¥, Millions) Discounted @ 6.8%

CN¥657

CN¥672

CN¥674

CN¥666

CN¥651

CN¥633

CN¥612

CN¥589

CN¥566

CN¥543

("Est" = FCF growth rate estimated by Simply Wall St)

Present Value of 10-year Cash Flow (PVCF)

= CN¥6.3b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 10-year government bond rate (2.0%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 6.8%.

Story continues

Terminal Value (TV)

= FCF

2029

× (1 + g) ÷ (r – g) = CN¥1.0b× (1 + 2.0%) ÷ 6.8%– 2.0%) = CN¥22b

Present Value of Terminal Value (PVTV)

= TV / (1 + r)

10

= CN¥22b÷ ( 1 + 6.8%)

10

= CN¥12b

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¥18b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of HK$6.7, the company appears a touch undervalued at a 24% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

SEHK:1448 Intrinsic value, December 1st 2019

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Fu Shou Yuan International 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 6.8%, which is based on a levered beta of 0.800. 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.

Next Steps:

Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to 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, the output can look very different. What is the reason for the share price to differ from the intrinsic value? For Fu Shou Yuan International Group, There are three pertinent factors you should further research:

Financial Health

: Does 1448 have a healthy balance sheet? Take a look at our

free balance sheet analysis with six simple checks

on key factors like leverage and risk.

Future Earnings

: How does 1448'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 High Quality Alternatives

: Are there other high quality stocks you could be holding instead of 1448? Explore

our interactive list of high quality stocks

to get an idea of what else is out there you may be missing!

PS. Simply Wall St updates its DCF calculation for every HK stock every day, so if you want to find the intrinsic value of any other stock just

search here

.

If you spot an error that warrants correction, please contact the editor at

[email protected]

. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.

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