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

Summary

This article looks at the valuation of China Telecom shares trading on the Stock Exchange of Hong Kong (Ticker: 00728.HK). The Dividend Discount Model is used to estimate the share's Intrinsic Value, Expected Return on Investment, and its Margin of Safety.

Introduction

China Telecom is one of the 3 giant state-owned companies which dominate the telecommunications industry in China, the other two being China Mobile and China Unicom. On November 12, 2020, Trump issued Executive Order 13959 prohibiting US investors from owning securities of Chinese companies which have been tagged by the US as being Chinese military companies, including China Telecom. ADRs of China Telecom trading on the New York Stock Exchange were suspended on January 11, 2021 and were subsequently delisted.

Following the US action against its ADRs, China Telecom successfully applied for secondary listing on the Shanghai Stock Exchange and its A-shares began trading in August 2021, raising over 54 billion RMB for the company. The IPO was a resounding success, attracting 20 strategic investors, including Huawei Technologies and Bilibili.

As part of the requirement for its secondary listing on the Shanghai Stock Exchange, China Telecom made some important changes to its dividend policy:

Three important points to note here with regards to the new dividend policy.

• • China Telecom to its increase dividend payout ratio for FY2021 to not less than 60%.

• • China Telecom also committed "that within three years after the A Share Offering and Listing, the profit to be distributed by the Company in cash for each year will gradually increase to 70% or above of the profit attributable to equity holders of the Company for that year." (Source: Company announcement 21 June 2021)

• • In contrast to the current policy of annual payouts, dividends shall be paid on an interim basis starting from FY 2022.

The new dividend policy is important in the sense that it increases the frequency of cash flow for investors, and it also serves to reduce the amount of surplus cash held on China Telecom's books and will potentially boost the Return on Equity.

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 China Telecom (00728.HK) shares trading on the Stock Exchange of Hong Kong.

China Telecom's Dividend and Earnings Track Record for FY2010 to FY2020

The table above summarizes the historical earnings per share and dividends per share for FY2010 to FY2020, using data sourced from China Telecom's Annual Reports. The following are worth noting:

1. 1. Shareholder's Equity grew at a compounded annual growth rate (CAGR) of 4.62%.

1. 1. Basic Earnings per share (EPS) grew at a compounded annual growth rate (CAGR) of 3.12%.

1. 1. Dividend per share (DPS) grew at a compounded annual growth rate (CAGR) of 3.84%.

China Telecom has a consistent track record of growing its dividends, earnings and shareholder equity. However, past performance is not indicative of future performance.

Does China Telecom (00728.HK) currently offer an attractive dividend yield (above the average yield of Hang Seng Index constituents)?

For FY2020, China Telecom declared dividends of 0.125HK$ per ordinary share. On 27th October 2021, the shares of China Telecom closed at 2.73HK$ per share. This translates into a dividend yield of 4.58% which is substantially higher than the average dividend yield of the constituent stocks of Hang Seng Index, which is approximately 3.61% according to AAStocks.

Data Source: AAStocks.com

Is China Telecom's Dividend Payout considered sustainable?

In FY2020, China Telecom reported free cash flow of 14,276 million RMB and paid out 8,403 million RMB as dividends. The free cash flow coverage of its dividend payout is 1.7 times. The average Free Cash flow coverage ratio of its dividends from FY2018 to FY2020 is 2.15 times, which is considered to be safe or sustainable.

10 year Dividend Discount Model for China Telecom

In order to evaluate the investment worthiness of China Telecom 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 China Telecom H-shares. The Dividend Discount Model is adopted for this purpose. The key parameters for the cash flow model are as follows:

Model Assumptions

The following assumptions were used in building up the Discounted Earnings Model for China Telecom.

• • Beta = 0.7 (Average of data from Infrontanalytics, Marketwatch and Reuters)

• • Market Risk Premium = 10.5% (Based on Market Risk Premia data for Hong Kong, November 2021)

• • Risk Free Rate = 1.473% (Based on 10 year Hong Kong Govt Bond Yield on 27th October 2021)

• • Expected Return on Capital Asset, Ke = 1.473% + 0.7 x 10.5% = 8.823%

• • Time period = 10 years (From Fiscal Year 2021 to 2030)

• • Annual EPS Growth Rate is modeled to decline gradually from 3.5% in 2021 to 2.51% in FY2030.  The resulting CAGR in earnings from FY2021 to FY2030 is 3.01%.

• • The Dividends are modeled to grow at CAGR of 8.856% from FY2021 to FY2030, assuming the payout ratio increases from 60% in FY2021 to 70% in FY2023 and remains at that level.

• • The Book Value per share is modeled to at CAGR of 1.959% from FY2021 to FY2030.

• • The terminal value is estimated from the Price to Book Value using the equation below: 

• • Sustainable growth rate = 2.5%.

• • Quantity of ordinary shares (fully diluted) = 91,507.14 million.

• • Currency exchange rate = 1.21HK$/RMB

The 10 year Dividend Discount Model is as shown below:

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

1. 1. Based on a discount rate of 8.823%, the intrinsic value of the China Telecom H-share is estimated at 3.361HK$ per share. The margin of safety is 18.76% based on the closing price of 2.73HK$ on 27th October 2021.

1. 1. Using the goal seek function of Excel, the discount rate which will yield an intrinsic value of 2.73HK$ is calculated to be 10.334%. This value of 10.334%  is the Expected Return on Investment for China Telecom H-shares at a cost basis of 2.73HK$ per share, over a 10-year period.

How does China Telecom 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 China Telecom (00728.HK) measures up against these benchmarks. Based on the share price of 2.73HK$ per share, the following observations are made:

• • Trailing PE Ratio:
    • • EPS FY2020 = 0.2576RMB = 0.3117HK$
    • • PE = 2.73/0.3117 = 8.759
    • • The price represents an opportunity to own a stake in the second largest Telecommunication company in China at a PE of less than 9.

• • PBV Ratio:
    • • Book Value FY2020 = 4.49RMB = 5.434HK$ per share
    • • PBV = 2.73/5.434 = 0.502 
    • • The Return on Equity of China Telecom (00728.HK) in FY2020 is 5.74%. Using a discount rate of 8.823% and a perpetual growth rate of 2.5%, the expected PBV can be estimated to be 0.512. The H-share is fairly valued at current price.

Conclusion

In this article, I set out to document the rationale behind an investment decision to purchase the China Telecom shares trading on the Stock Exchange of Hong Kong. Based on a discount rate of 8.823%, the Intrinsic Value of China Telecom is estimated to be 3.361HK$ providing a comfortable margin of safety of 18.76%. Additionally, at the price of 2.73HK$ per share, the Expected Return on Investment is estimated to be 10.324%  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.