Estimating The Intrinsic Value Of Shanghai Industrial Holdings Limited (HKG:363)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Shanghai Industrial Holdings fair value estimate is HK$14.36
• Shanghai Industrial Holdings' HK$14.85 share price indicates it is trading at similar levels as its fair value estimate
• The average discount for Shanghai Industrial Holdings' competitorsis currently 64%

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Shanghai Industrial Holdings Limited (HKG:363) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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.

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The 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.

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

	2026	2027	2028	2029	2030	2031	2032	2033	2034	2035
Levered FCF (HK$, Millions)	HK$1.75b	HK$1.73b	HK$1.73b	HK$1.75b	HK$1.77b	HK$1.81b	HK$1.84b	HK$1.89b	HK$1.94b	HK$1.99b
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ 0.03%	Est @ 0.87%	Est @ 1.45%	Est @ 1.86%	Est @ 2.15%	Est @ 2.35%	Est @ 2.49%	Est @ 2.59%
Present Value (HK$, Millions) Discounted @ 13%	HK$1.6k	HK$1.4k	HK$1.2k	HK$1.1k	HK$961	HK$867	HK$783	HK$709	HK$643	HK$584

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = HK$9.7b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 5-year average of the 10-year government bond yield (2.8%) 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 13%.

Terminal Value (TV)= FCF₂₀₃₅ × (1 + g) ÷ (r – g) = HK$2.0b× (1 + 2.8%) ÷ (13%– 2.8%) = HK$20b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= HK$20b÷ ( 1 + 13%)¹⁰= HK$5.9b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is HK$16b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of HK$14.9, the company appears around fair value at the time of writing. 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.

The Assumptions

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. 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 Shanghai Industrial Holdings 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.

View our latest analysis for Shanghai Industrial Holdings

SWOT Analysis for Shanghai Industrial Holdings

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or 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. For Shanghai Industrial Holdings, there are three essential elements you should assess:

1. Risks: Be aware that Shanghai Industrial Holdings is showing 1 warning sign in our investment analysis , you should know about...
2. Future Earnings: How does 363'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.
3. 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 SEHK every day. If you want to find the calculation for other stocks just search here.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.