Tongkun Group's estimated fair value is CN¥12.41 based on 2 Stage Free Cash Flow to Equity
Current share price of CN¥15.06 suggests Tongkun Group is potentially 21% overvalued
Analyst price target for 601233 is CN¥16.43, which is 32% above our fair value estimate
Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Tongkun Group Co., Ltd. (SHSE:601233) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
Crunching The Numbers
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) forecast
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
Levered FCF (CN¥, Millions)
CN¥1.01b
CN¥1.50b
CN¥2.02b
CN¥2.53b
CN¥3.00b
CN¥3.42b
CN¥3.78b
CN¥4.09b
CN¥4.36b
CN¥4.60b
Growth Rate Estimate Source
Analyst x1
Est @ 48.40%
Est @ 34.75%
Est @ 25.20%
Est @ 18.51%
Est @ 13.83%
Est @ 10.55%
Est @ 8.25%
Est @ 6.65%
Est @ 5.52%
Present Value (CN¥, Millions) Discounted @ 13%
CN¥899
CN¥1.2k
CN¥1.4k
CN¥1.6k
CN¥1.7k
CN¥1.7k
CN¥1.7k
CN¥1.6k
CN¥1.5k
CN¥1.4k
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = CN¥15b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (2.9%) 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 13%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥49b÷ ( 1 + 13%)10= CN¥15b
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¥30b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of CN¥15.1, the company appears slightly overvalued at the time of writing. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.
Important Assumptions
We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual 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 Tongkun Group 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 13%, which is based on a levered beta of 1.713. 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.
SWOT Analysis for Tongkun Group
Strength
Debt is well covered by earnings.
Balance sheet summary for 601233.
Weakness
Dividend is low compared to the top 25% of dividend payers in the Chemicals market.
Opportunity
Annual earnings are forecast to grow faster than the Chinese market.
Good value based on P/E ratio compared to estimated Fair P/E ratio.
Threat
Debt is not well covered by operating cash flow.
Annual revenue is forecast to grow slower than the Chinese market.
Is 601233 well equipped to handle threats?
Looking Ahead:
Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value lower than the current share price? For Tongkun Group, there are three further aspects you should further examine:
Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Tongkun Group (at least 1 which is a bit unpleasant) , and understanding these should be part of your investment process.
Future Earnings: How does 601233'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.
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. Simply Wall St updates its DCF calculation for every Chinese stock every day, so if you want to find the intrinsic value of any other stock just search here.
Have feedback on this article? Concerned about the content?Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com. 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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com