Does Kingdee International Software Group Company Limited (HKG:268)’s share price in March reflect what it’s really worth? Today we are going to estimate the intrinsic value of the stock by taking the expected future cash flows and discounting them to the present value. Our analysis will 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.
Check out our latest analysis for Kingdee International Software Group
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 (CN¥, Million)||604.2 million Canadian yen||CN¥934.4m||CN¥1.55b||CN¥2.18b||CN¥2.79b||CN¥3.24b||CN¥3.62b||CN¥3.93b||CN¥4.19b||CN¥4.40b|
|Growth rate estimate Source||Analyst x4||Analyst x4||Analyst x1||Analyst x1||Analyst x1||Is at 16.2%||Is at 11.78%||Is at 8.69%||Is at 6.53%||Is at 5.01%|
|Present value (CN¥, million) discounted at 6.4%||CN¥568||CN¥826||CN¥1.3k||CN¥1.7k||CN¥2.0k||CN¥2.2k||CN¥2.3k||CN¥2.4k||CN¥2.4k||CN¥2.4k|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = CN¥18b
After calculating the present value of future cash flows over the initial 10-year period, we need to calculate the terminal value, which takes into account all future cash flows beyond 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 terminal cash flows to present value at a cost of equity of 6.4%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = CN¥4.4b × (1 + 1.5%) ÷ (6.4%–1.5%) = CN¥91b
Present value of terminal value (PVTV)= TV / (1 + r)ten= CN¥91b÷ ( 1 + 6.4%)ten= CN¥49b
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is 67 billion Canadian yen. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of HK$18.5, the company looks slightly undervalued at a 22% discount to the current share price. 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 Kingdee International Software 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 takes debt into account. In this calculation, we used 6.4%, which is based on a leveraged beta of 0.994. 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.
Valuation is only one side of the coin in terms of building your investment thesis, and it’s just one of many factors you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, if the terminal value growth rate is adjusted slightly, it can significantly change the overall result. Why is the stock price below intrinsic value? For Kingdee International Software Group, we have compiled three relevant factors that you should delve into:
- Risks: Take for example the ubiquitous specter of investment risk. We have identified 1 warning sign with Kingdee International Software Group, and understanding it should be part of your investment process.
- Future earnings: How does 268’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 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. Simply Wall St updates its DCF calculation for every Hong Kong stock daily, so if you want to find the intrinsic value of any other stock, just 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.