# Tencent Holdings Limited (0700 HKG) Investment Valuation

February 19th, 2013 Posted by No Comment yet

Tencent Holdings Limited is a Chinese multinational investment holding conglomerate founded in 1998. The subsidiaries specialize in various Internet-related services and products, entertainment, artificial intelligence, and technology.

## Tencent Value Investing Approach

This method of valuation approach for Tencent Holdings Ltd was based on the Discounted Model.  The historical data was calculated. And then we come up with the projected financial data and ratios to come up with the net present value of the 6th year period. Net present value is one way to decide if an investment is worthwhile by looking at the projected cash inflows and outflows.

## Tencent Discounted Cash Flow Approach

The formula for the discounted cash flow is: Where:

• Vo is the value of the equity of a business today.
• CF1 to CFn represent the expected cash flows (or benefits) to be derived for periods 1 to n.  The discounted cash flow model is based on time periods of time of equal length.
• r is the discount rate that converts future dollars of CF into present dollars of value.

The equation above is the basic discounted cash flow (DCF) model. #### Explanation

The Discounted Cash Flow spreadsheet shows the historical income and expense plus the equity data in the total amount and per share.  The present value of equity was \$26.35 at a rate of 29.80 percent.  The future value of \$96.94 is equal to the present value of \$26.35. This means, leaving you a choice of having \$26.35 today or wait for the 6 time periods to have \$96.94 per share. If you take the \$26.35 today, you will have a chance to reinvest the money at 29.80 percent at the same equal time periods which will end up having more than \$26.35.  Moreover, the projected net income for year 5 was \$32.05 per share a total value of \$59.62 billion, while the present value was \$25.7 billion.

On the other hand, the capital rate that was used was 15 percent. The future value of equity was \$312.9 billion at a future price of \$168.25 per share. While the present value of Tencent Holdings Ltd was \$135 billion at \$72.74 per share. The return on investment that was used was 33.07 percent. While the price to earnings that were used in the calculation was \$5 and it’s earning per share was \$8.71.  The current market price, February 13, 2013, was \$35.10 per share.

## Tencent Investment in Enterprise Value

The concept of enterprise value is to calculate what it would cost to purchase an entire business. Enterprise Value (EV) is the present value of the entire company. Market capitalization, on the other hand, is the total value of the company’s equity shares. In essence, EV is a company’s theoretical takeover price, because the buyer would have to buy all of the stock and pay off existing debt while pocketing any remaining cash. This gives the buyer solid grounds for making its offer. #### Explanation

The market capitalization for Tencent Holdings Ltd was increasing except in 2011 where it experienced a drop of 8 percent. The total debt represents 6 percent average, while the cash and cash equivalent represent a 78 percent average. As a result, the enterprise value was lesser by 72 percent against the market capitalization. If an investor decides to buy the entire business of Tencent Holdings Ltd, then he/she will be paying 100 percent of its equity, no debt, because cash was greater than the total debt.

The purchase price to date February 13, 2013, in buying the entire business of Tencent Holding Ltd was \$42.9 billion at \$23.07 per share. The market price to date was \$35.10 per share.

## Benjamin Graham’s Stock Test

### Net Current Asset Value (NCAV) Approach

Graham developed and tested the net current asset value (NCAV) approach between 1930 and 1932. Graham reported that the average return, over a 30-year period, on diversified portfolios of net current asset stocks was about 20 percent. An outside study showed that from 1970 to 1983, an investor could have earned an average return of 29.4 percent by purchasing stocks that fulfilled Graham’s requirement and holding them for one year.

### Net Current Asset Value (NCAV) Method

Studies have all shown that the Net Current Asset Value (NCAV) method of selecting stocks has outperformed the market significantly.

Graham was looking for firms trading so cheap that there was little danger of falling further.  His strategy calls for selling when a firm’s share price trades up to its net current asset value. The reason for this according to Graham is when a stock is trading below the Net Current Asset Value Per Share, they are essentially trading below the company’s liquidation value and therefore, the stock was trading at a bargain, and it is worth buying.

The concept of this method is to identify stocks trading at a discount to the company’s Net Current Asset Value per Share, specifically two-thirds or 66percent of net current asset value. #### Explanation

The net current asset value approach of Benjamin Graham indicates that the stock price was overvalued from 2007 to 2012. Because the market value was greater than the 66 percent ratio. The 66 percent ratio represents only 18 percent of the market value. Thus, the stock was trading above the liquidation value of Tencent Holdings Inc.

It tells us that the stock of Tencent did not pass the stock test of Benjamin Graham because the price was expensive.

### Market Capitalization/Net Current Asset Value (MC/NCAV) Valuation

By calculating market capitalization over the net current asset value of the company, we will know if the stocks are trading over or undervalued. The result should be less than 1.2 ratios. Graham would only buy if the ratio does not exceed 1.2 ratios.

Formula: Market Capitalization / NCAV = Result (must be lesser than 1.2)

Let’s go over with the result from the table below: The MC/NCAV valuation tells us that the stock price of Tencent was overvalued from 2007 to 2012. Because it exceeded the 1.2 ratios. It did not pass the stock test of Graham because the stock was expensive.

### Benjamin Graham’s Margin of Safety (MOS)

The margin of Safety requires knowing when the buying price is low in absolute terms, rather than merely relative to the market as a whole. This formula is used to identify the difference between company value and price.Graham called it the intrinsic value.

This is the concept taught by Benjamin Graham and still referred to by Warren Buffett. Value investing is buying with a sufficient margin of safety. Graham considers buying when the market price is considerably lower than the intrinsic or real value, a minimum of 40 to 50 percent below. Because enterprise value takes into account the balance sheet and a much more accurate measure of the company’s true value compared to market capitalization,

To arrive at the results below for Tencent Holdings Ltd, we used the formula Margin of Safety = Enterprise Value – Intrinsic Value. #### Explanation

Benjamin Graham’s margin of safety indicates a 96 percent average for Tencent Holdings Ltd. The margin of safety was at \$282 average. The enterprise value was average \$10 representing only 3 percent of the intrinsic value, while on the other hand, the intrinsic value was average \$292 representing 3041 percent of the enterprise value.

#### Intrinsic Value

Intrinsic Value = Current Earnings x (9 + 2 x Sustainable  Growth Rate)

The explanation in the calculation of intrinsic value was as follows:

EPS or the company’s last 12-month earnings per share; G as the company’s long-  term (five years) sustainable growth estimate; 9 is the constant that represents the appropriate P-E ratio for a no-growth company; and 2 for the average yield of high-grade corporate bonds. #### Explanation

What factors intrinsic value? In our calculation, using the formula of Benjamin Graham for intrinsic value, the earning per share and the growth plays an important role in the calculations. The earning per share was \$3 average, while the sustainable growth rate was 39 average. On the other hand, the annual growth rate was 86 average.

#### Earnings per Share (EPS)

The formula for earning per share was: Sustainable growth rate (SGR), on the other hand, shows how fast a company can grow using internally generated assets without issuing additional debt or equity. To calculate the sustainable growth rate for a company, you need to know its return on equity (ROE). You also need to know the dividend payout ratio. From there, multiply the company’s ROE by its blowback ratio, which is equal to 1 minus the dividend payout ratio.

#### Sustainable Growth Rate

Sustainable growth rate = ROE x (1 – dividend-payout ratio) The table above shows that the return on equity was average 42 percent while the payout ratio was 8 percent average.

Let’s move on with Return on Equity or ROE. This is used as an indicator of a company’s profitability by measuring how much profit the company generates with the money invested by common stock owners. In other words, the return on equity shows how many dollars of earnings result from each dollar of equity. The formula for the return on equity was: #### Relative and Average Approach

The summary of the two approaches is in the table below. Let us walk farther and see how is the real value of the stock of Tencent Holdings Ltd and the market price of the stock significant in the margin of safety. #### Explanation

The intrinsic value line soared up very high at a rate of 2969 percent average from 2007 to the trailing twelve months 2012. This is the true value of the stock of Tencent Holdings Ltd. This means that the true value of the stock is soaring high, but in the trailing twelve months of 2012, it falls down at -9 percent. The price was stable at an average of \$10, trending at 13 percent average.  The graph shows a 96 percent average margin of safety from 2007. Overall, this is what Benjamin Graham meant, when he said, purchasing at a discount to its underlying intrinsic value.

IV is the true value of the stock and EV is the market price and the difference between the two lines is what we called the margin of safety.

## Tencent Relative Valuation Methods

The main purpose of these relative valuation methods for valuing a stock is to compare market values of the stock with the fundamentals (earnings, book value, growth multiples, cash flow, and other metrics) of the stock.

### Price to Earnings/Earning Per Share (P/E*EPS)

This valuation will determine the status of the stock price. Stocks may be undervalued or overvalued.  One way to do this is by simply multiplying the Price to Earnings (P/E) ratio with the company’s relative Earning per Share (EPS) and comparing it to the enterprise value per share. #### Explanation

The P/E*EPS valuation shows that the price was undervalued from 2007 to the trailing twelve months 2012. The enterprise value represents only 8 percent of the P/E*EPS ratio, therefore, the price was cheap.

The price was undervalued because the stock price was lesser than the result of the P/E*EPS ratio. Another way of calculating this valuation is by using the average price to earnings ratio. Price to earnings ratio using the average approach has greater results because it takes into consideration the past performance of the company, in which the P/E ratio for 2006 was 5000 percent.

### The Enterprise Value (EV)/Earning Per Share (EPS) or (EV/EPS)

The use of this ratio is to separate price and earnings in the enterprise value. By dividing the enterprise value of projected earnings (EPS). The result represents the price (P/E) and the difference represents the earnings (EPS).  If the analysts think that the appropriate ratio is greater or lower than the result. #### Explanation

The EV/EPS valuation indicates that the price (P/E) that was separated represents 36 percent average. While the earnings (EPS) a were 64 percent average. This might indicate that the price was cheap because the price represents only one-third of the enterprise value.

### Enterprise Value (EV)/ Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA) or (EV/EBITDA)

This metric is used in estimating business valuation. It compares the value of the company inclusive of debt to the actual cash earnings exclusive of non-cash expenses. This metric is useful for analyzing and comparing profitability between companies and industries. #### Explanation

The EV/EBITDA valuation tells us that it will take three years to cover the cost of buying the entire business. In other words, it will take three times the cash earnings to cover the cost of the purchase price. This valuation also shows the profitability wherein, it has a 74 percent average gross profit margin. Likewise, its net margin was 38 percent average.

Conclusion:

In the Discounted Cash Flow spreadsheet, the capital rate that was used was 15 percent.  The present value of equity per share was \$26.35 at the rate of 33.07 percent. While the future value was \$96.94 per share discounted today at present value. Taking the amount of \$96.94 today, you will be able to reinvest at the same 33.07 percent for the same equal 6 time period. Also, end up getting a higher amount. Moreover, the future value of equity was \$312.9 billion at a future price of \$168.25 per share. While the present value of Tencent was \$135 billion at \$72.74 per share. In addition, the projected income at year 5 was \$32.05 per share discounted at present value.

#### Enterprise Value

The enterprise value valuation, total debt represents 6 percent and the cash and cash equivalent represent 78 percent. Thus the enterprise value was lesser by 72 percent against the market value. Buying the entire business to date, December 26, 2012, will cost \$37.5 billion at 20.16 per share.

#### Net Current Asset

The net current asset value approach of Benjamin Graham indicates that the stock price of Tencent was overvalued. For the reason, the stock was trading above the liquidation value of the company. MC/NCAV valuation, on the other hand, shows that the stock price was expensive because the ratio exceeded the 1.2 ratios. Further, the margin of safety for Tencent Holdings Ltd was 96 percent average. While the intrinsic value was \$292 average. In addition, the sustainable growth rate was \$39 and ROE was \$42 average.

#### Relative Valuation

Taking consideration of the relative valuation, it shows that the stock price was undervalued. Because the price (P/E) represents 36 percent. While the earnings (EPS) was 64 percent average in the EV/EPS valuation.  Moreover, the P/E EPS valuation shows that the price was undervalued because the price represents only 8 percent average.

#### EV/EBITDA

Furthermore, the EV/EBITDA valuation tells us that it will take 3 years to cover the costs of buying the business. In other words, it will take 3 times the earnings of the company to cover the costs of buying. The gross and net margins were 74 and 38 percent average.

Overall, the stock price was cheap and the margin of safety was 96 percent average. Moreover, the company has an impressive gross and net margins at 74 and 38 percent, respectively. Moreover, the return on equity was 42 percent average. Therefore I recommend a BUY in the stock of Tencent Holdings Ltd.

Research and written by Cris

This investment valuation is a bit different from our previous report.