How far is Stella International Holdings Limited (HKG: 1836) from its intrinsic value? Using the most recent financial data, we’ll examine whether the stock price is fair by taking expected future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Believe it or not, it’s not too hard to follow, as you will see in our example!

There are many ways that businesses can be assessed, so we would like to point out that a DCF is not perfect for all situations. If you still have burning questions about this type of valuation, take a look at Simply Wall St.

Check out our latest analysis for Stella International Holdings

Is Stella International Holdings properly valued?

We use the 2-step growth model, which simply means that we take into account two stages of business growth. During the initial period, the business can have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To begin with, we need to estimate the next ten years of cash flow. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated 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 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

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 589 million

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 6.7%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = US $ 85 million × (1 + 1.5%) ÷ (6.7% to 1.5%) = US $ 1.7 billion

Present value of terminal value (PVTV)= TV / (1 + r)^ten= US $ 1.7 billion ÷ (1 + 6.7%)^ten= US $ 875 million

Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is US $ 1.5 billion. 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 $ 8.4, the company appears to be quite undervalued with a 42% discount from 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.

Important assumptions

We draw your attention to the fact that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. 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 Stella International 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 takes debt into account. In this calculation, we used 6.7%, which is based on a leveraged beta of 1.061. 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.

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 business. The DCF model is not a perfect stock assessment 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 dramatically change the overall result. What is the reason why the stock price is below intrinsic value? For Stella International Holdings, there are three relevant factors you should research further:

1. Risks: You should be aware of the 2 warning signs for Stella International Holdings we found out before considering an investment in the business.
2. Future benefits: How does the growth rate of 1836 compare with that of its peers and the market at large? Dig deeper into the analyst consensus number for years to come by interacting with our free analyst growth expectations chart.
3. Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what you might be missing!

PS. Simply Wall St updates its DCF calculation for every Hong Kong stock every day, so if you want to find the intrinsic value of any other stock 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 documents. Simply Wall St has no position in any of the stocks mentioned.

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