Estimated fair value of Legend Holdings Corporation (HKG:3396)
Today we’ll walk through one way to estimate the intrinsic value of Legend Holdings Corporation (HKG:3396) by taking the company’s expected future cash flows and discounting them to the present value. This will be done using the discounted cash flow (DCF) model. Patterns like these may seem beyond a layman’s comprehension, but they’re pretty easy to follow.
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. Anyone interested in learning a little more about intrinsic value should read the Simply Wall St.
Check out our latest analysis for Legend Holdings
What is the estimated valuation?
We use the 2-stage growth model, which simply means that we consider two stages of business growth. In the initial period, the company may have a higher growth rate, and the second stage is generally assumed to have a stable growth rate. To begin with, we need to obtain cash flow estimates for the next ten years. Since no analyst estimate of free cash flow is available, we have extrapolated the previous free cash flow (FCF) from the company’s latest 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.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, and so the sum of these future cash flows is then discounted to today’s value:
Estimated free cash flow (FCF) over 10 years
|Leveraged FCF (CN¥, Million)||CN¥5.11b||CN¥3.00b||CN¥2.15b||CN¥1.73b||CN¥1.50b||CN¥1.37b||CN¥1.29b||CN¥1.25b||CN¥1.22b||CN¥1.21b|
|Growth rate estimate Source||Is @ -59.55%||East @ -41.24%||Is @ -28.42%||East @ -19.45%||Is @ -13.17%||Is @ -8.78%||East @ -5.7%||Is @ -3.55%||East @ -2.04%||Is @ -0.98%|
|Present value (CN¥, million) discounted at 11%||CN¥4.6k||CN¥2.4k||CN¥1.6k||CN¥1.1k||CN¥877||CN¥718||CN¥608||CN¥527||CN¥464||CN¥412|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = CN¥13b
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. For a number of reasons, a very conservative growth rate is used which cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (1.5%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 11%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = CN¥1.2b × (1 + 1.5%) ÷ (11%– 1.5%) = CN¥12b
Present value of terminal value (PVTV)= TV / (1 + r)ten= CN¥12b÷ ( 1 + 11%)ten= CN¥4.2b
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is 18 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$9.4, the company appears around fair value at the time of writing. The assumptions of any calculation have a big impact on the valuation, so it’s best to consider this as a rough estimate, not accurate down 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 coming up with your own assessment of a company’s future performance, so try the math yourself and check your own 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 view Legend 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 factors in debt. In this calculation, we used 11%, which is based on a leveraged beta of 2,000. 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.
Although a business valuation is important, it is only one of many factors you need to assess for a business. The DCF model is not a perfect stock valuation tool. 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. For Legend Holdings, we’ve rounded up three more things you should consider in more detail:
- Risks: You should be aware of the 3 warning signs for Legend Holdings (1 is disturbing!) that we discovered before considering an investment in the company.
- Future earnings: How does the growth rate of 3396 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. The Simply Wall St app performs an updated cash flow assessment for each SEHK stock every day. If you want to find the calculation for other stocks, 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.