Does the August share price for Alibaba Health Information Technology Limited (HKG:241) reflect what it’s really worth? Today, we will estimate the stock’s intrinsic value by taking the expected future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they’re fairly easy to follow.
We generally believe that a company’s value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
Check out our latest analysis for Alibaba Health Information Technology
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second ‘steady growth’ period. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren’t available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
Generally we assume that a dollar today is more valuable than a dollar 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) forecast
|Levered FCF (CN¥, Millions)||CN¥793.0m||CN¥1.57b||CN¥1.69b||CN¥2.27b||CN¥3.78b||CN¥4.61b||CN¥5.35b||CN¥5.97b||CN¥6.48b||CN¥6.90b|
|Growth Rate Estimate Source||Analyst x4||Analyst x5||Analyst x3||Analyst x1||Analyst x1||Est @ 22.15%||Est @ 15.95%||Est @ 11.61%||Est @ 8.57%||Est @ 6.44%|
|Present Value (CN¥, Millions) Discounted @ 5.8%||CN¥749||CN¥1.4k||CN¥1.4k||CN¥1.8k||CN¥2.8k||CN¥3.3k||CN¥3.6k||CN¥3.8k||CN¥3.9k||CN¥3.9k|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥27b
The second stage is also known as Terminal Value, this is the business’s cash flow after the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country’s GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (1.5%) to estimate future growth. In the same way as with the 10-year ‘growth’ period, we discount future cash flows to today’s value, using a cost of equity of 5.8%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = CN¥6.9b× (1 + 1.5%) ÷ (5.8%– 1.5%) = CN¥161b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥161b÷ ( 1 + 5.8%)10= CN¥92b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is CN¥118b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of HK$12.2, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula – garbage in, garbage out.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. Part of investing is coming up with your own evaluation of a company’s future performance, so try the calculation yourself and check your own assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company’s future capital requirements, so it does not give a full picture of a company’s potential performance. Given that we are looking at Alibaba Health Information Technology 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 accounts for debt. In this calculation we’ve used 5.8%, which is based on a levered beta of 0.816. Beta is a measure of a stock’s volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to “what assumptions need to be true for this stock to be under/overvalued?” For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Alibaba Health Information Technology, there are three further factors you should further research:
- Risks: Consider for instance, the ever-present spectre of investment risk. We’ve identified 2 warning signs with Alibaba Health Information Technology , and understanding these should be part of your investment process.
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for 241’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- Other Solid Businesses: 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 business fundamentals to see if there are other companies you may not have considered!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the SEHK every day. If you want to find the calculation for other stocks just search here.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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