In this article, we will estimate the intrinsic value of Wharf Real Estate Investment Company Limited (HKG:1997) by estimating the company’s future cash flows and discounting them to their present value. The discounted cash flow (DCF) model is the tool we will use for this. Believe it or not, it’s not too difficult to follow as you will see from our example!
We generally believe that a company’s value is the present value of all the cash it will generate in the future. However, a DCF is just one evaluation metric among many, and it is not without its shortcomings. If you want to know more about the intrinsic value, you should read the Simply Wall St analysis model.
Check out our latest analysis for Wharf Real Estate Investment
We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first phase is generally a higher growth phase that levels off towards the terminal value captured in the second phase of ‘steady growth’. In the first phase, we need to estimate the cash flows for the company over the next ten years. Where possible we use analyst estimates, but when these are not available we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We expect companies with declining free cash flow to slow their rate of contraction and companies with growing free cash flow to slow their growth rate over this period. We do this to take into account that growth tends to slow down more in the early years than in later years.
In general, we assume a dollar is more valuable today than a dollar will be in the future, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) estimate.
|Leveraged FCF (HK$, millions)||4.89 billion HKD||HK$7.64 billion||HK$7.77 billion||8.59 billion HKD||HKD9.28 billion||HKD9.77 billion||HK$10.2 billion||HK$10.5 billion||10.8 billion HKD||HK$11.1 billion|
|Source of growth rate estimate||Analyst x3||Analyst x3||Analyst x3||Analyst x1||Analyst x1||Estimated @ 5.28%||Estimated @ 4.14%||Estimated @ 3.34%||Estimated at 2.78%||Estimated at 2.39%|
|Present Value (HK$, millions) Discounted at 7.5%||4.5,000HKD||6.6,000HKD||6.3,000HKD||6.4,000HKD||6.5,000HKD||6.3,000HKD||6.1,000HKD||5.9,000HKD||5.6,000HKD||5.4,000HKD|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present value of 10-year cash flow (PVCF) = 60 billion HKD
The second stage is also known as the terminal value, this is the company’s cash flow after the first stage. A very conservative growth rate is used, which cannot exceed a country’s GDP growth, for a number of reasons. In this case, we used the 5-year average of the 10-year government bond yield (1.5%) to estimate future growth. As with the 10-year “growth period,” we discount future cash flows to today’s value using a cost of equity rate of 7.5%.
final value (TV)= FCF2031 × (1 + g) ÷ (r – g) = HK$11B × (1 + 1.5%) ÷ (7.5% – 1.5%) = HK$187B
Present value of terminal value (PVTV)= TV / (1 + r)10= HK$187b÷ (1 + 7.5%)10= HK$91 billion
The total value is the sum of the cash flows for the next ten years plus the discounted terminal value, giving the total equity value, which in this case is HK$150 billion. In the final step, we divide the equity value by the number of outstanding shares. Compared to the current share price of HK$37.2, the company appears slightly undervalued at a discount of 25% to the current share price. The assumptions in each calculation have a big impact on the score, so it’s better to take this as a rough estimate, not accurate to the last penny.
Now the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. Part of investing is creating your own estimate of a company’s future performance, so try the calculation yourself and check your own assumptions. The DCF also does not take into account the potential cyclicality of an industry or a company’s future capital needs, so it does not provide a complete picture of a company’s potential performance. As we view Wharf Real Estate Investment as a potential shareholder, 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 financing. In this calculation we used 7.5% which is based on a leveraged beta of 1.243. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the industry average of global peers, with an imposed limit of between 0.8 and 2.0, which is a reasonable range for a stable business.
While important, the DCF calculation is ideally not the only analysis you review 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 how they would affect the company’s valuation. If a company is growing at a different rate, or if its cost of equity or risk-free rate changes significantly, the outcome can be very different. Why is the intrinsic value higher than the current share price? For Wharf Real Estate Investment, we have compiled three other elements for you to examine:
- risks: We think you should judge that 2 Warning Signs for Wharf Real Estate Investment we marked before we made an investment in the company.
- future earnings: How does the 1997 growth rate compare to its competitors and the broader market? Dive deeper into analyst consensus numbers for the years ahead by interacting with our free analyst growth expectations chart.
- Other solid companies: Low debt, high returns on equity and good past performance are fundamental to a strong company. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered?
hp Simply Wall St updates its DCF calculation for each Hong Kong stock daily. So if you want to find the intrinsic value of another stock, just search here.
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This Simply Wall St article is of a general nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended as financial advice. It is not a recommendation to buy or sell any stock and does not take into account your goals or financial situation. Our goal is to offer you long-term focused analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any of the stocks mentioned.