How far is Inspur International Limited (HKG:596) from its intrinsic value? Using the most recent financial data, we will examine whether the stock price is fair by taking the company’s expected future cash flows and discounting them to the present value. One way to do this is to use the discounted cash flow (DCF) model. This may sound complicated, but it’s actually quite simple!

Businesses can be valued in many ways, which is why we emphasize that a DCF is not perfect for all situations. If you still have burning questions about this type of assessment, take a look at Simply Wall St.’s analysis template.

Check out our latest analysis for Inspur International

The model

We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “sustained growth”. In the first step, we need to estimate the company’s cash flow over the next ten years. Since no analyst estimates of free cash flow are available to us, we have extrapolated the previous free cash flow (FCF) from the company’s latest reported 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 more in early years than in later years.

Generally, we assume that a dollar today is worth more than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today’s dollars:

Estimated free cash flow (FCF) over 10 years

(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = HK$1.1 billion

The second stage is also known as the terminal value, it 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 10-year government bond yield of 1.5%. We discount terminal cash flows to present value at a cost of equity of 6.3%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = HK$155 million × (1 + 1.5%) ÷ (6.3%–1.5%) = HK$3.2 billion Kong

Present value of terminal value (PVTV)= TV / (1 + r)^ten= HK$3.2 billion÷ (1 + 6.3%)^ten= HK$1.8 billion

The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is HK$2.8 billion. In the last step, we divide the equity value by the number of shares outstanding. Against the current share price of HK$2.7, the company appears around fair value at the time of writing. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep that in mind.

Important assumptions

The above calculation is highly dependent on two assumptions. One is the discount rate and the other is the cash flows. If you disagree with these results, try the math yourself and play around with the assumptions. 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 complete picture of a company’s potential performance. Since we view Inspur International 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 debt into account. In this calculation, we used 6.3%, which is based on a leveraged beta of 1.002. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

Let’s move on :

While important, calculating DCF shouldn’t be the only metric to consider when researching a business. It is not possible to obtain an infallible valuation with a DCF model. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, if the terminal value growth rate is adjusted slightly, it can significantly change the overall result. For Inspur International, you need to consider three additional factors:

1. Risks: For example, we found 1 warning sign for Inspur International that you must consider before investing here.
2. Future earnings: How does 596’s growth rate compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
3. Other strong companies: Low debt, high returns on equity and good past performance are essential to a strong business. Why not explore our interactive list of stocks with strong trading fundamentals to see if there are any other companies you may not have considered!

PS. Simply Wall St updates its DCF calculation for every Hong Kong stock daily, so if you want to find the intrinsic value of any other stock, just search here.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.