Calculation of the fair value of Cathay Pacific Airways Limited (HKG: 293)
How far is Cathay Pacific Airways Limited (HKG: 293) from its intrinsic value? Using the most recent financial data, we’ll examine whether the stock price is fair by estimating the company’s future cash flows and discounting them to their present value. One way to do this is to use the Discounted Cash Flow (DCF) model. Don’t be put off by the lingo, the math is actually pretty straightforward.
We draw your attention to the fact that there are many ways to assess a business and, like DCF, each technique has advantages and disadvantages in certain scenarios. If you would like to know more about discounted cash flows, the rationale for this calculation can be read in detail in the Simply Wall St analysis model.
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Crunch the numbers
We use the 2-step growth model, which simply means that we take into account two stages of business growth. In the initial period, the business can have a higher growth rate, and the second stage is usually assumed to have a stable growth rate. In the first step, we need to estimate the cash flow of the business over the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated value. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we discount the value of those future cash flows to their estimated value in today’s dollars. hui:
10-year free cash flow (FCF) forecast
|Leverage FCF (HK $, Million)||HK $ 3.90 billion||HK $ 6.08 billion||HK $ 4.20 billion||HK $ 4.06 billion||HK $ 3.99 billion||HK $ 3.97 billion||HK $ 3.96 billion||HK $ 3.98 billion||HK $ 4.01 billion||HK $ 4.04 billion|
|Source of growth rate estimate||Analyst x4||Analyst x4||Analyst x1||Analyst x1||Is @ -1.7%||East @ -0.75%||East @ -0.08%||East @ 0.39%||East @ 0.72%||Is @ 0.95%|
|Present value (HK $, Million) discounted @ 11%||3.5k HK $||HK $ 5.0k||HK $ 3.1k||2.7k HK $||2.4k HK $||2.2k HK $||2.0k HK $||HK $ 1.8k||1.6k HK $||1.5k HK $|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = HK $ 26 billion
The second stage is also known as terminal value, this is the cash flow of the business after the first stage. The Gordon growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.5%. We discount terminal cash flows to their present value at a cost of equity of 11%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = HK $ 4.0 billion × (1 + 1.5%) ÷ (11% – 1.5%) = HK $ 45 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= 45 billion HK $ ÷ (1 + 11%)ten= HK $ 16 billion
Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is HK $ 42 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of HK $ 7.1, the company appears to be around fair value at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it’s best to take this as a rough estimate, not precise down to the last penny.
Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play with them. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a full picture of a company’s potential performance. Since we view Cathay Pacific Airways 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 takes into account debt. In this calculation, we used 11%, which is based on a leveraged beta of 1.874. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Valuation is only one side of the coin in terms of building your investment thesis, and it’s just one of the many factors you need to evaluate for a business. DCF models are not the alpha and omega of investment valuation. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. For Cathay Pacific Airways, there are three fundamental factors that you need to consider further:
- Financial health: 293 Does he 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.
- Future benefits: How does 293’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth expectations chart.
- Other strong companies: 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 trading fundamentals to see if there are other companies you might not have considered!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for each SEHK share. If you want to find the calculation for other actions, do a search here.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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