In this article we are going to estimate the intrinsic value of AAC Technologies Holdings Inc. (HKG:2018) by projecting its future cash flows and then discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
View our latest analysis for AAC Technologies Holdings
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To start off with, we need to estimate the next ten years of cash flows. 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, so we discount the value of these future cash flows to their estimated value in today's dollars:
2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | 2033 | 2034 | |
Levered FCF (CN¥, Millions) | CN¥2.96b | CN¥3.46b | CN¥3.59b | CN¥3.71b | CN¥3.82b | CN¥3.93b | CN¥4.04b | CN¥4.15b | CN¥4.26b | CN¥4.37b |
Growth Rate Estimate Source | Analyst x5 | Analyst x3 | Est @ 3.74% | Est @ 3.35% | Est @ 3.08% | Est @ 2.89% | Est @ 2.75% | Est @ 2.66% | Est @ 2.59% | Est @ 2.55% |
Present Value (CN¥, Millions) Discounted @ 8.7% | CN¥2.7k | CN¥2.9k | CN¥2.8k | CN¥2.7k | CN¥2.5k | CN¥2.4k | CN¥2.3k | CN¥2.1k | CN¥2.0k | CN¥1.9k |
("Est" = FCF growth rate estimated by Simply Wall St)Present Value of 10-year Cash Flow (PVCF) = CN¥24b
The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (2.4%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 8.7%.
Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = CN¥4.4b× (1 + 2.4%) ÷ (8.7%– 2.4%) = CN¥72b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥72b÷ ( 1 + 8.7%)10= CN¥31b
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¥56b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of HK$50.9, the company appears around fair value at the time of writing. 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 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 AAC Technologies Holdings 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 8.7%, which is based on a levered beta of 1.183. 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.
Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For AAC Technologies Holdings, there are three fundamental aspects you should consider:
PS. Simply Wall St updates its DCF calculation for every Hong Kong stock every day, so if you want to find the intrinsic value of any other stock just search here.
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