The Hong Kong and China Gas Company Limited's (HKG:3) Intrinsic Value Is Potentially 83% Above Its Share Price

Simply Wall St.2023-11-14

Key Insights The projected fair value for Hong Kong and China Gas is HK$9.86 based on 2 Stage Free Cash Flow to Equity Hong Kong and China Gas is estimated to be 45% undervalued based on current ...

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Using the most recent financial data, we'll take a look at whether the stock is fairly priced  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.  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.  Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.  View our latest analysis for Hong Kong and China Gas  The Method   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.   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  2024 2025 2026 2027 2028 2029 2030 2031 2032 2033  Levered FCF (HK$, Millions)  HK$6.07b HK$7.11b HK$7.88b HK$8.52b HK$9.05b HK$9.50b HK$9.89b HK$10.2b HK$10.5b HK$10.8b Growth Rate Estimate Source Analyst x1 Analyst x1 Est @ 10.76% Est @ 8.12% Est @ 6.27% Est @ 4.98% Est @ 4.08% Est @ 3.45% Est @ 3.00% Est @ 2.69%  Present Value (HK$, Millions) Discounted @ 6.7%  HK$5.7k HK$6.2k HK$6.5k HK$6.6k HK$6.5k HK$6.4k HK$6.3k HK$6.1k HK$5.9k HK$5.7k (\"Est\" = FCF growth rate estimated by Simply Wall St)Present Value of 10-year Cash Flow (PVCF) = HK$62b 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 (2.0%) 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 6.7%. Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = HK$11b× (1 + 2.0%) ÷ (6.7%– 2.0%) = HK$233bPresent Value of Terminal Value (PVTV)= TV / (1 + r)10= HK$233b÷ ( 1 + 6.7%)10= HK$122b The total value, or equity value, is then the sum of the present value of the future cash flows,  which in this case is HK$184b.  To get the intrinsic value per share, we divide this by the total number of shares outstanding.  Compared to the current share price of HK$5.4, the company appears   quite undervalued    at a 45% discount to where the stock price trades currently.   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:3 Discounted Cash Flow November 14th 2023  The Assumptions  Now 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 Hong Kong and China Gas 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 6.7%, which is based on a levered beta of 0.800. 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 Hong Kong and China GasStrength Earnings growth over the past year exceeded the industry. Debt is well covered by earnings. Balance sheet summary for 3. Weakness Dividend is low compared to the top 25% of dividend payers in the Gas Utilities market.Opportunity Annual earnings are forecast to grow for the next 3 years. Trading below our estimate of fair value by more than 20%. ThreatDebt is not well covered by operating cash flow. Dividends are not covered by earnings and cashflows.  Annual earnings are forecast to grow slower than the Hong Kong market. Is 3 well equipped to handle threats?  Moving On:  Valuation is only one side of the coin in terms of building your investment thesis, and it  shouldn't be the only metric you look at when researching 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?\"  If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different.   Why is the intrinsic value higher than the current share price?   For Hong Kong and China Gas, we've compiled three  important  items  you should assess:   Risks: Every company has them, and we've spotted   2 warning signs for Hong Kong and China Gas   you should know about.   Future Earnings: How does 3'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 Hong Kong stock every day, so if you want to find the intrinsic value of any other stock just search here.Valuation is complex, but we're helping make it simple.Find out whether Hong Kong and China Gas is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.View the Free AnalysisHave 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. 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