A look at the intrinsic value of South Manganese Investment Limited (HKG: 1091)
In this article, we will estimate the intrinsic value of South Manganese Investment Limited (HKG: 1091) by taking expected future cash flows and discounting them to today’s value. To this end, we will take advantage of the Discounted Cash Flow (DCF) model. It may sound complicated, but it’s actually quite simple!
Remember, however, that there are many ways to estimate the value of a business, and a DCF is just one method. If you still have burning questions about this type of valuation, take a look at the Simply Wall St.
Check out our latest review for South Manganese Investment
Step by step in the calculation
We are going to use a two-step 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 “steady growth”. In the first step, 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.
In general, we assume that a dollar today is worth more than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at an estimate of the present value:
10-year Free Cash Flow (FCF) estimate
| 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | |
| Leverage FCF (HK $, Million) | HK $ 296.3 million | HK $ 306.1 million | HK $ 314.6 million | HK $ 322.1 million | HK $ 328.9 million | HK $ 335.2 million | HK $ 341.2 million | HK $ 347.0 million | HK $ 352.7 million | HK $ 358.3 million |
| Source of estimated growth rate | Est @ 4.11% | East @ 3.32% | East @ 2.77% | East @ 2.38% | Est @ 2.11% | Est @ 1.92% | Est @ 1.79% | East @ 1.7% | East @ 1.63% | Is @ 1.59% |
| Present value (HK $, Million) discounted at 9.6% | 270 HK $ | 255 HK $ | 239 HK $ | 223 HK $ | 208 HK $ | 193 HK $ | HK $ 180 | 167 HK $ | 155 HK $ | 143 HK $ |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = HK $ 2.0 billion
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 step. 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 the terminal cash flows to their present value at a cost of equity of 9.6%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = HK $ 358 million × (1 + 1.5%) ÷ (9.6% – 1.5%) = HK $ 4.5 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= 4.5 billion HK $ ÷ (1 + 9.6%)ten= HK $ 1.8 billion
Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is HK $ 3.8 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of HK $ 1.3, the company appears to be around fair value at the time of writing. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.
Important assumptions
Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. 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 full picture of a company’s potential performance. Since we consider South Manganese Investment 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 9.6%, which is based on a leveraged beta of 1.528. 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 from globally comparable companies, with a limit imposed between 0.8 and 2.0, which is a reasonable range for a stable business.
Next steps:
Valuation is only one side of the coin in terms of building your investment thesis, and ideally, it won’t be the only piece of analysis you look at for a business. DCF models are not the alpha and omega of investment valuation. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. 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 South Manganese Investment, we’ve put together three fundamentals that you should explore:
- Risks: You should be aware of the 2 warning signs for South Manganese Investment (1 is significant!) That we discovered before considering an investment in the company.
- 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 might not have considered!
- Other picks from top analysts: Interested in seeing what analysts think? Take a look at our interactive list of analysts’ top stock picks to find out what they think might have a compelling outlook for the future!
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.
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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 documents. Simply Wall St has no position in the mentioned stocks.
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