Evaluating Tencent's Cash-Flow-Derived Intrinsic Value

| About: Tencent Holding (TCEHY)


We think an intrinsic value estimate is a vital step in any investment-decision process, regardless of the business model.

Tencent's future growth opportunities are tremendous, and its ValueCreation rating is solid.

We value shares just north of $70 each, implying modest upside.

As part of our process, we perform a discounted cash flow methodology that dives into the true intrinsic worth of companies. In Tencent's (OTCPK:TCEHY) case, we think the firm is fairly valued at $73 per ADR, implying modest upside from its current ADR price at the time of this writing (about $60).

Before we dig in, let's go through a little background about our process to help with the terminology. At Valuentum, we think a comprehensive analysis of a firm's discounted cash flow valuation, relative valuation versus industry peers, as well as an assessment of technical and momentum indicators is the best way to identify the most attractive stocks at the best time to buy. This process culminates in what we call our Valuentum Buying Index, which ranks stocks on a scale from 1 to 10, with 10 being the best. Essentially, we're looking for firms that overlap investment methodologies, thereby revealing the greatest interest by investors (we like firms that fall in the center of the diagram below):

At the methodology's core, if a company is undervalued both on a discounted cash flow basis and on a relative valuation basis and is showing improvement in technical and momentum indicators, it scores high on our scale. Tencent posts a Valuentum Buying Index score of 6 on our scale, reflecting our "fairly valued" DCF assessment of the firm, its unattractive relative valuation versus peers, and bullish technicals. A score of 6 is rather good, and while its technicals have soured a bit since our last update, we're keeping a close eye on the firm. Let's now dig into the Valuentum valuation report.

Tencent's Investment Considerations

Investment Highlights

  • Tencent earns a ValueCreation™ rating of EXCELLENT, the highest possible mark on our scale. The firm has been generating economic value for shareholders for the past few years, a track record we view very positively. Return on invested capital (excluding goodwill) has averaged 171.4% during the past three years.
  • Tencent has grown into China's largest and most used Internet service portal. Its diversified services include QQ, Weixin, and WeChat for communications; Qzone for social networking; QQ Game Platform for online games; and QQ.com for information.
  • Recent results continue to be impressive, making our forward forecasts for a 25% top line CAGR during the next five years (and our fair value estimate) potentially conservative. Total revenues jumped nearly 40% during the first half of 2013 as sales from ecommerce transactions and online advertising surged.
  • The company continues to position itself well for the mobile revolution. Recent investments have achieved deep mobile engagement, as evidenced by rapidly increasing usage of apps such as Mobile QQ, Mobile Qzone, Weixin, and WeChat on smart phones.
  • eBay has recently partnered with Tencent to launch a Chinese e-commerce joint venture. We think opportunities related to combining social media with payment infrastructure could yield tremendous results over the long haul.

Business Quality

Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. Tencent's 3-year historical return on invested capital (without goodwill) is 171.4%, which is above the estimate of its cost of capital of 11.3%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead, based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. Tencent's free cash flow margin has averaged about 41.2% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures, and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. For more information on the differences between these two measures, please visit our website at Valuentum.com. At Tencent, cash flow from operations increased about 58% from levels registered two years ago, while capital expenditures expanded about 146% over the same time period.

Valuation Analysis

Our discounted cash flow model indicates that Tencent's ADRs are worth between $57-$90 each. The margin of safety around our fair value estimate is driven by the firm's MEDIUM ValueRisk™ rating, which is derived from the historical volatility of key valuation drivers. The estimated fair value of $73 per ADR represents a price-to-earnings (P/E) ratio of about 63.9 times last year's earnings and an implied EV/EBITDA multiple of about 48.6 times last year's EBITDA. These are lofty multiples, but they reasonably reflect the company's future growth trajectory. Our model reflects a compound annual revenue growth rate of 27% during the next five years, a pace that is lower than the firm's 3-year historical compound annual growth rate of 52.2%. Our model reflects a 5-year projected average operating margin of 31.8%, which is below Tencent's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 10.5% for the next 15 years and 3% in perpetuity. For Tencent, we use a 11.3% weighted average cost of capital to discount future free cash flows.

Our discounted cash flow process allows us to arrive at an absolute view of the firm's intrinsic value. However, we also understand the critical importance of assessing firms on a relative value basis versus both their industry and peers. Many institutional money-managers -- those that drive stock prices -- pay attention to a company's price-to-earnings ratio and price-earning-to-growth ratio in making buy/sell decisions. With this in mind, we have included a forward-looking relative value assessment in our process to further augment our rigorous discounted cash flow process. If a company is undervalued on both a price-to-earnings ratio and a price-earnings-to-growth ratio versus industry peers, we would consider the firm to be attractive from a relative value standpoint. We compare Tencent to peers Baidu (NASDAQ:BIDU), Facebook (NASDAQ:FB), Google (NASDAQ:GOOG), and Yahoo (YHOO).

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $73 per ADR, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future was known with certainty, we wouldn't see much volatility in the markets, as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety, or the fair value range we assign to each stock. In the graph below, we show this probable range of fair values for Tencent. We think the firm is attractive below $57 per ADR (the green line), but quite expensive above $90 per ADR (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate Tencent's fair value at this point in time to be about $73 per ADR. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart below compares the firm's current share price with the path of Tencent's expected equity value per ADR over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's ADRs three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $102 per ADR in Year 3 represents our existing fair value per ADR of $73 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

Pro Forma Financial Statements

In the spirit of transparency, we show how the performance of the Valuentum Buying Index has stacked up per underlying score as it relates to firms in the Best Ideas portfolio. Past results are not a guarantee of future performance.

Disclosure: BIDU, GOOG are included in the Best Ideas portfolio. I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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