Estimating the Intrinsic Value, Return on Investment and Margin of Safety of Ping An using the Dividend Discount Model

Summary

This article looks at the valuation of Ping An shares trading on the Stock Exchange of Hong Kong (Ticker: 2318.HK). The Dividend Discount Model is used to estimate the share's Intrinsic Value, Expected Return on Investment, and its Margin of Safety.

Continue reading to learn more.

Introduction

Ping An is the 3rd largest insurance company in the world by market capitalization and by the same measure, is the largest insurance company in Mainland China. Ping An has its humble beginning in Shenzhen when it was founded in 1988 at China's first joint-stock company. Since then, its business has grown by leaps and bounds and it has diversified into other profitable business ventures, including fin-tech and banking. The company was successfully listed on the Stock Exchange of Hong Kong on 24th June 2004.

Ping An shares hit its 52-week high on the Hong Kong Stock Exchange in January this year. Since that price top, the share has undergone a prolonged correction, culminating in its recent 52-week low 49.00HK$ per share on 21st September 2021. All in all, the share price has declined more than 50% from its year high.
Such a massive correction in one of the largest insurance companies in the world has certainly attracted the attention of many in the investment community. The time is right to have a closer look at the current valuation of Ping An (2318.HK) shares trading on the Stock Exchange of Hong Kong.

Dividend Discount Model is one of many methods for valuing stocks. The procedure is similar to the Discounted Cash Flow model, with the free cash flow being substituted dividends as the cash flowing to the investor. One advantage of using this method is that dividends data are easily available from the company's financial reports. It is also my preferred valuation method for dividend-paying stocks. The reason being that dividends are tangible income to the investor and it represents the return of investment and return on investment. The cash from dividends allows the investor to reinvest the proceeds into the same stock or into other more attractive stocks to achieve the all important compounding effect.

This article describes the use of the Dividend Discount Model to determine the Intrinsic Value, Expected Return on Investment, and Margin of Safety of Ping An (2318.HK) shares trading on the Stock Exchange of Hong Kong.

Ping An's Dividend and Earnings Track Record for FY2004 to FY2020

The above historical charts are obtained from Ping An's Annual Report for FY 2020. It is testament to Ping An's impressive growth rate since its IPO in 2004.

1. Shareholder's Equity grew at a compounded annual growth rate (CAGR) of 22.9%.
2. Basic Earnings per share (EPS) grew at a compounded annual growth rate (CAGR) of 23.4%.
3. Dividend per share (DPS) grew at a compounded annual growth rate (CAGR) of 24.0%.
4. Embedded Value grew at a compounded annual growth rate (CAGR) of 25.0%.
5. Total Assets grew at a compounded annual growth rate (CAGR) of 25.1%.

Ping An certainly has an undergone a tremendous growth phase since its IPO in 2004. In addition, Ping An also has a consistent track record of growing its dividends, earnings and shareholder equity. However, past performance is not indicative of future performance.

Does Ping An (2318.HK) currently offer an attractive dividend yield (above the average yield of Hang Seng Index constituents)?

For FY2020, Ping An declared dividends of 2.19RMB per ordinary share, which is equivalent to 2.628HK$. On 20th September 2021, the shares of Ping An closed at 51.35HK$ per share. This translates into a dividend yield of 5.12% which is substantially higher than the average dividend yield of the constituent stocks of Hang Seng Index, which is approximately 3.76% according to AAStocks.

Data Source: AAStocks.com

Is Ping An's Dividend Payout considered sustainable?

In FY2020, Ping An's operational cash flow is 312,075 million RMB and its capital expenditure is 9,995 million RMB. Its Free Cash Flow per share is estimated as (312075-9995)/17995 = 16.79RMB per share. In FY2020 Ping An paid out 2.19RMB per share of dividend to its ordinary shareholders. The free cash flow coverage of its dividend payout is 7.66x, which is considered to be safe or sustainable.

10 year Dividend Discount Model for Ping An

In order to evaluate the investment worthiness of Ping An going forward, a cash flow analysis is used to determine a reasonable estimate of the Intrinsic Value, Expected Return on Investment and Margin of Safety of the H-shares of Ping An. The Dividend Discount Model is adopted for this purpose. Key parameters for the cash flow model are as follows:

Model Assumptions

The following assumptions were used in building up the Dividend Discount Model for Ping An (2318.HK).

• Beta = 1.1 (This is the approximately the average of the beta figure from Reuters, Marketwatch.com and Infrontanalytics.com)
• Market Risk Premium = 10.5% (Based on Market Risk Premia data for Hong Kong, November 2008)
• Risk Free Rate = 1.077% (Based on 10 year Hong Kong Govt Bond Yield on 20th September 2021)
• Expected Return on Capital Asset, Ke = 1.077% + 1.1 x 10.5% = 12.627%
• Time period = 10 years (From Fiscal Year 2021 to 2030)
• Annual Earnings Growth Rate is modeled to decline gradually to 8.80% in FY2030. The resulting CAGR in earnings from FY2021 to FY2030 is 9.56%. This is a drastic decline from the CAGR of 23.4% achieved from FY2004 to FY2020.
• The Dividends are modeled to grow at CAGR of 9.46% from FY2021 to FY2030, assuming the payout ration remains unchanged at 27%. This is a conservative assumption, considering that the CAGR of Dividends from FY2004 to FY2020 = 24%.
• The Book Value per share is modeled to at CAGR of 12.735% from FY2021 to FY2030. Again, this is a conservative assumption, considering that the CAGR of Shareholders' Equity from FY2004 to FY2020 = 22.9%.
• The terminal value is estimated from the Price to Book Value using the equation below: 

• Sustainable growth rate = 3.0%.
• Quantity of ordinary shares (fully diluted) = 17,795 million.
• Currency exchange rate = 1.2HK$/RMB

The 10 year Dividend Discount Model is as shown below:

With reference to the summary table above, the following can be noted :

1. Based on a discount rate of 12.627%, the intrinsic value of the share is estimated at 85.765HK$ per share. The margin of safety is 40.13% based on the closing price of 51.35HK$ on 20th September 2021.
2. Using the goal seek function of Excel, the discount rate which will yield an intrinsic value of 51.35HK$ is calculated to be 16.365%. This value of 16.365%  is the Expected Return on Investment for Ping An shares at a cost basis of 51.35HK$ per share, over a 10-year period.

How does Ping An measure against the Traditional Value Investing Benchmarks?

Some popular yardsticks to gauge the value of stocks as investments include the Price to Earnings ratio and the Price to Book Value ratio. In this section, we will see how the Ping An (2318.HK) measures up against these benchmarks. Based on the share price of 51.35HK$ per share, the following observations are made:

• Trailing Price to Earnings (PE) Ratio:
  • EPS FY2020 = 8.04RMB = 9.65HK$
  • PE = 51.35/9.65 = 5.322
  • The price represents an opportunity to own a stake in one of the largest insurance company in the world, in terms of market capitalization, at an attractive discount with a payback period of less than 6 years.
• Price to Book Value (PBV) Ratio:
  • Book Value FY2020 = 41.71RMB = 50.05HK$ per share
  • PBV = 51.35/50.05 = 1.026
  • The Return on Equity of Ping An (2318.HK) in FY2020 is 19.28%. Using a discount rate of 12.627% and a growth rate of 3%, the expected PBV can be estimated to be 1.691. This represents an upside of 64.8% from the current PBV of 1.026.

Conclusion

In this article, I set out to document the rationale behind an investment decision to purchase the Ping An shares trading on the Stock Exchange of Hong Kong. Based on a discount rate of 12.627%, the Intrinsic Value of Ping An is estimated to be 51.35HK$ providing a substantial margin of safety of 40.13%. Additionally, at a purchase price of 51.35HK$ per share, the Expected Return on Investment is estimated to be an attractive 16.365%  per annum.

Disclaimer:

This article is a record of the thinking behind a personal investment decision. It does not represent any recommendation to purchase any stock mentioned in the article. As always, readers are strongly advised to do their own due diligence before making any investment decisions.