A look at the fair value of Prosperous Printing Company Limited (HKG: 8385)
Does the November share price of Prosperous Printing Company Limited (HKG: 8385) reflect its true value? Today we’re going to estimate the intrinsic value of the stock by taking expected future cash flows and discounting them to their present value. Our analysis will use the discounted cash flow (DCF) model. Don’t be put off by the lingo, the underlying calculations are actually pretty straightforward.
Remember, however, that there are many ways to estimate the value of a business, and a DCF is just one method. For those who are passionate about equity analysis, the Simply Wall St analysis template here may be something of interest to you.
Check out our latest review for Prosperous Printing
What is the estimated valuation?
We use what is called a two-step model, which simply means that we have two different periods of growth rate for the cash flow of the business. Usually, the first stage is higher growth, and the second stage is a lower growth stage. First, we need to estimate the cash flow of the business over the next ten years. Since no free cash flow analyst estimate is available, we have extrapolated the previous free cash flow (FCF) from the last reported value of the company. 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 down more in the early years than in subsequent years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, and therefore the sum of those future cash flows is then discounted to today’s value. :
10-year Free Cash Flow (FCF) estimate
|Leverage FCF (HK $, Million)||HK $ 7.22 million||HK $ 7.68 million||HK $ 8.06 million||HK $ 8.38 million||HK $ 8.65 million||HK $ 8.88 million||HK $ 9.08 million||HK $ 9.27 million||HK $ 9.45 million||HK $ 9.61 million|
|Source of estimated growth rate||East @ 8.6%||Est @ 6.46%||Est @ 4.97%||Est @ 3.92%||Est @ 3.19%||East @ 2.68%||East @ 2.32%||East @ 2.07%||East @ 1.89%||East @ 1.77%|
|Present value (HK $, Millions) discounted at 11%||6.5 HK $||6.2 HK $||HK $ 5.9||5.5 HK $||5.1 HK $||4.7 HK $||4.3 HK $||3.9 HK $||3.6 HK $||3.3 HK $|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = HK $ 48 million
The second stage is also known as terminal value, this is the cash flow of the business after 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 of the 10-year government bond yield of 1.5%. We discount terminal cash flows to their present value at a cost of equity of 11%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = HK $ 9.6 million × (1 + 1.5%) ÷ (11% – 1.5%) = HK $ 100 million
Present value of terminal value (PVTV)= TV / (1 + r)ten= HK $ 100m ÷ (1 + 11%)ten= HK $ 34 million
Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is HK $ 82 million. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of HK $ 0.1, the company appears to be roughly at fair value with a 2.8% discount to the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.
Now the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. If you don’t agree with these results, try the calculation yourself and play 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 full picture of a company’s potential performance. Since we view Prosperous Printing 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 into account debt. In this calculation, we used 11%, which is based on a leveraged beta of 2,000. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our beta from the industry average beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
To move on :
While important, calculating DCF shouldn’t be the only metric you look at when looking for a business. It is not possible to achieve a rock-solid valuation with a DCF model. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. For Prosperous Printing, we have compiled three fundamental aspects that you should research further:
- Risks: Take risks, for example – Prosperous Printing a 3 warning signs (and 1 which doesn’t suit us very well) we think you should be aware of.
- Other strong companies: 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 trading fundamentals to see if there are other companies you may not have considered!
- Other environmentally friendly companies: Are you concerned about the environment and think that consumers will buy more and more environmentally friendly products? Browse our interactive list of companies thinking about a greener future to discover stocks you may not have thought of!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for each SEHK share. If you want to find the calculation for other actions, just search here.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in any of the stocks mentioned.
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