How far off is Chinasoft International Limited (HKG:354) from its intrinsic value? Using the most recent financial data, I am going to take a look at whether the stock is fairly priced by taking the foreast future cash flows of the company and discounting them back to today’s value. I will be using the discounted cash flows (DCF) model. It may sound complicated, but actually it is quite simple! If you want to learn more about discounted cash flow, the basis for my calcs can be read in detail in the Simply Wall St analysis model. If you are reading this and its not November 2018 then I highly recommend you check out the latest calculation for Chinasoft International by following the link below.

View our latest analysis for Chinasoft International

The model

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 five years. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount this to its value today and sum up the total to get the present value of these cash flows.

5-year cash flow forecast

Present Value of 5-year Cash Flow (PVCF)= CN¥2.8b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after the five years. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 2.2%. We discount this to today’s value at a cost of equity of 10.3%.

Terminal Value (TV) = FCF₂₀₂₂ × (1 + g) ÷ (r – g) = CN¥1.0b × (1 + 2.2%) ÷ (10.3% – 2.2%) = CN¥13b

Present Value of Terminal Value (PVTV) = TV / (1 + r)⁵ = CN¥13b ÷ ( 1 + 10.3%)⁵ = CN¥7.7b

The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is CN¥11b. In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number. This results in an intrinsic value of HK$4.89. Relative to the current share price of HK$4.52, the stock is about right, perhaps slightly undervalued at a 7.5% discount to what it is available for right now.

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don’t agree with my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Chinasoft International as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 10.3%, which is based on a levered beta of 1.041. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

Next Steps:

Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. For 354, I’ve compiled three relevant aspects you should further research:

1. Financial Health: Does 354 have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.

2. Future Earnings: How does 354’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.

3. Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of 354? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. Simply Wall St does a DCF calculation for every HK stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.