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Hong Kong and China Gas' estimated fair value is HK$10.87 based on 2 Stage Free Cash Flow to Equity

Current share price of HK$5.79 suggests Hong Kong and China Gas is potentially 47% undervalued

Our fair value estimate is 88% higher than Hong Kong and China Gas' analyst price target of HK$5.78

Today we will run through one way of estimating the intrinsic value of The Hong Kong and China Gas Company Limited (HKG:3) by estimating the company's future cash flows and discounting them to their present value.  Our analysis will employ the Discounted Cash Flow (DCF) model.  There's really not all that much to it， even though it might appear quite complex.

Remember though， that there are many ways to estimate a company's value， and a DCF is just one method.  If you still have some burning questions about this type of valuation， take a look at the Simply Wall St analysis model.

Check out our latest analysis for Hong Kong and China Gas

The Calculation

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.  To start off with， we need to estimate the next ten years of cash flows.   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，  so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

2024

2025

2026

2027

2028

2029

2030

2031

2032

2033

Levered FCF (HK$， Millions)

HK$5.02b

HK$6.58b

HK$7.75b

HK$8.77b

HK$9.62b

HK$10.3b

HK$10.9b

HK$11.4b

HK$11.9b

HK$12.3b

Growth Rate Estimate Source

Analyst x2

Analyst x2

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Est @ 17.86%

Est @ 13.09%

Est @ 9.76%

Est @ 7.42%

Est @ 5.79%

Est @ 4.64%

Est @ 3.84%

Est @ 3.28%

Present Value (HK$， Millions) Discounted @ 6.7%

HK$4.7k

HK$5.8k

HK$6.4k

HK$6.8k

HK$7.0k

HK$7.0k

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HK$6.9k

HK$6.8k

HK$6.6k

HK$6.4k

("Est" = FCF growth rate estimated by Simply Wall St)

Present Value of 10-year Cash Flow (PVCF) = HK$64b

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$12b× (1 + 2.0%) ÷ (6.7%– 2.0%) = HK$265b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= HK$265b÷ ( 1 + 6.7%)10= HK$138b

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$203b.  The last step is to then divide the equity value by the number of shares outstanding.  Compared to the current share price of HK$5.8， the company appears   quite good value    at a 47% discount to where the stock price trades currently.   Valuations are imprecise instruments though，佛山市场问卷调查 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 December 26th 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.  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 Gas

Strength

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%.

Threat

Debt 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?

Looking Ahead:

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.  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.   What is the reason for the share price sitting below the intrinsic value?   For Hong Kong and China Gas， there are three  additional  items  you should further examine:

Risks: For example， we've discovered 2 warning signs for Hong Kong and China Gas that you should be aware of before investing here.

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 High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

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.

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.

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