Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of China Telecom Corporation Limited (HKG:728) as an investment opportunity by estimating the company’s future cash flows and discounting them to their present value. I will be using the Discounted Cash Flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. 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 December 2018 then I highly recommend you check out the latest calculation for China Telecom by following the link below.

Check out our latest analysis for China Telecom

Step by step through the calculation

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 the sum of these cash flows to arrive at a present value estimate.

5-year cash flow estimate

Present Value of 5-year Cash Flow (PVCF)= CN¥98b

After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. 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¥31b × (1 + 2.2%) ÷ (10.3% – 2.2%) = CN¥387b

Present Value of Terminal Value (PVTV) = TV / (1 + r)⁵ = CN¥387b ÷ ( 1 + 10.3%)⁵ = CN¥236b

The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is CN¥334b. 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$4.67. Compared to the current share price of HK$3.92, the stock is about right, perhaps slightly undervalued at a 16% discount to what it is available for right now.

Important assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don’t have to agree with my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at China Telecom 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 1.044. 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 728, I’ve compiled three relevant factors you should further examine:

1. Financial Health: Does 728 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 728’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 728? 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.