Using the 2 Stage Free Cash Flow to Equity, Sinoma International EngineeringLtd fair value estimate is CN¥15.10
Current share price of CN¥11.04 suggests Sinoma International EngineeringLtd is potentially 27% undervalued
Our fair value estimate is 5.1% higher than Sinoma International EngineeringLtd's analyst price target of CN¥14.36
Today we will run through one way of estimating the intrinsic value of Sinoma International Engineering Co.,Ltd (SHSE:600970) by taking the expected future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Believe it or not, it's not too difficult to follow, as you'll see from our example!
We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
The Model
We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) forecast
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
Levered FCF (CN¥, Millions)
CN¥2.87b
CN¥3.91b
CN¥3.88b
CN¥2.78b
CN¥2.79b
CN¥2.82b
CN¥2.87b
CN¥2.93b
CN¥3.00b
CN¥3.07b
Growth Rate Estimate Source
Analyst x2
Analyst x2
Analyst x1
Analyst x1
Est @ 0.31%
Est @ 1.10%
Est @ 1.65%
Est @ 2.04%
Est @ 2.31%
Est @ 2.50%
Present Value (CN¥, Millions) Discounted @ 9.4%
CN¥2.6k
CN¥3.3k
CN¥3.0k
CN¥1.9k
CN¥1.8k
CN¥1.6k
CN¥1.5k
CN¥1.4k
CN¥1.3k
CN¥1.3k
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = CN¥20b
The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.9%. We discount the terminal cash flows to today's value at a cost of equity of 9.4%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥49b÷ ( 1 + 9.4%)10= CN¥20b
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is CN¥40b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of CN¥11.0, the company appears a touch undervalued at a 27% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.
The Assumptions
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at Sinoma International EngineeringLtd 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 accounts for debt. In this calculation we've used 9.4%, which is based on a levered beta of 1.141. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
SWOT Analysis for Sinoma International EngineeringLtd
Strength
Earnings growth over the past year exceeded the industry.
Debt is well covered by earnings.
Dividends are covered by earnings and cash flows.
Dividend is in the top 25% of dividend payers in the market.
Dividend information for 600970.
Weakness
Earnings growth over the past year is below its 5-year average.
Opportunity
Annual earnings are forecast to grow for the next 3 years.
Good value based on P/E ratio and estimated fair value.
Threat
Debt is not well covered by operating cash flow.
Annual earnings are forecast to grow slower than the Chinese market.
Is 600970 well equipped to handle threats?
Next Steps:
Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Sinoma International EngineeringLtd, we've compiled three fundamental factors you should consider:
Risks: Be aware that Sinoma International EngineeringLtd is showing 1 warning sign in our investment analysis , you should know about...
Future Earnings: How does 600970's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!
PS. Simply Wall St updates its DCF calculation for every Chinese stock every day, so if you want to find the intrinsic value of any other stock just search here.
Have feedback on this article? Concerned about the content?Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com. This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.