Key Insights

• China BlueChemical's estimated fair value is HK$1.77 based on 2 Stage Free Cash Flow to Equity

• China BlueChemical's HK$1.82 share price indicates it is trading at similar levels as its fair value estimate

• China BlueChemical's peers seem to be trading at a higher premium to fair value based onthe industry average of -42%

In this article we are going to estimate the intrinsic value of China BlueChemical Ltd. (HKG:3983) by taking the 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.  Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation.  For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for China BlueChemical

Crunching The Numbers

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate.  To begin with, we have to get estimates of the next ten years of cash flows.   Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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.  

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today,  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) estimate

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥3.7b

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 (1.9%) 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 8.2%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = CN¥533m× (1 + 1.9%) ÷ (8.2%– 1.9%) = CN¥8.6b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥8.6b÷ ( 1 + 8.2%)10= CN¥3.9b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value,  which in this case is CN¥7.6b.  To get the intrinsic value per share, we divide this by the total number of shares outstanding.  Relative to the current share price of HK$1.8, the company appears   around fair value    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.

SEHK:3983 Discounted Cash Flow October 19th 2023

The 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 these inputs, I recommend redoing the calculations yourself and playing with them.  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 China BlueChemical 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 8.2%, which is based on a levered beta of 1.036. 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 China BlueChemical

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is not viewed as a risk.

• Dividend is in the top 25% of dividend payers in the market.

• Dividend information for 3983.

Weakness

• No major weaknesses identified for 3983.

Opportunity

• Good value based on P/E ratio compared to estimated Fair P/E ratio.

Threat

• Dividends are not covered by cash flow.

• See 3983's dividend history.

Moving On:

Whilst important, the DCF calculation  is only one of many factors that you need to assess for a company.  It's not possible to obtain a foolproof valuation with a DCF model.  Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?"  For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation.  For China BlueChemical, there are three  important  factors  you should assess:

1. Risks: For example, we've discovered 3 warning signs for China BlueChemical (2 are potentially serious!) that you should be aware of before investing here.

2. Future Earnings: How does 3983'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 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.