Anhui Honglu Steel Construction (Group) CO., LTD (SZSE:002541) shares could be 30% below their estimated intrinsic value

Key findings

• The estimated fair value of Anhui Honglu Steel Construction (Group) is CN¥24.89 based on the 2-step free cash flow to equity
• The current share price of CN¥17.43 suggests that Anhui Honglu Steel Construction (Group) may be undervalued by 30%
• The analyst price target of CN¥23.44 for 2541 is 5.8% below our fair value estimate

Today we’re going to go through one way to estimate the intrinsic value of Anhui Honglu Steel Construction (Group) CO., LTD (SZSE:002541) by taking the expected future cash flows and discounting them to their present value. We’re going to use the Discounted Cash Flow (DCF) model on this occasion. Believe it or not, it’s not too difficult to follow, as you’ll see from our example!

However, keep in mind that there are many ways to estimate the value of a company, and a DCF is just one of them. If you want to learn more about intrinsic value, you should check out Simply Wall St’s analysis model.

Check out our latest analysis for Anhui Honglu Steel Construction (Group)

The model

We use what is called a 2-stage model, which simply means that we have two different growth periods for the company’s cash flows. Generally speaking, the first stage is one of higher growth, and the second stage is one of lower growth. In the first stage, we need to estimate the company’s cash flows for 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 that companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will slow their growth rate, over this period. We do this to take into account that growth tends to slow more in the early years than in later years.

A DCF is based on the idea that a dollar in the future is worth less than a dollar today. Therefore, the sum of these future cash flows is discounted to today’s value:

Estimation of free cash flow (FCF) over 10 years

(“Est” = FCF growth rate, estimated by Simply Wall St)
Present value of 10-year cash flow (PVCF) = 7.5 billion CNY

We now need to calculate the terminal value that takes into account all future cash flows after this ten-year period. The Gordon growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year Treasury yield of 2.9%. We discount the terminal cash flows to today’s value at a cost of equity of 11%.

Final value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CN¥2.2b × (1 + 2.9%) ÷ (11% – 2.9%) = CN¥28b

Present value of terminal value (PVTV)= TV / (1 + r)¹⁰= CN¥28b÷ ( 1 + 11%)¹⁰= 9.6 billion CNY

The total value is the sum of the next ten years’ cash flows plus the discounted terminal value, which gives the total value of equity, which in this case is CNY17 billion. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of CNY17.4, the company seems to be somewhat undervalued at a 30% discount to the current share price. However, keep in mind that this is only an approximate valuation and as with any complex formula, where there’s garbage in, there’s garbage out.

Important assumptions

The key inputs to a discounted cash flow are the discount rate and, of course, the actual cash flows. Part of investing is making your own assessment of a company’s future performance, so try the calculation yourself and check your own assumptions. DCF also does not take into account the possible cyclicality of an industry or a company’s future capital needs, and therefore does not provide a complete picture of a company’s potential performance. Since we are considering Anhui Honglu Steel Construction (Group) as prospective 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 takes debt into account. In this calculation, we used 11%, which is based on a levered beta of 1.474. Beta is a measure of a stock’s volatility relative to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with a set limit between 0.8 and 2.0, which is a reasonable range for a stable company.

SWOT Analysis for Anhui Honglu Steel Construction (Group)

Next Steps:

While the DCF calculation is important, it is only one of many factors you need to evaluate a company. The DCF model is not a perfect tool for stock valuation. It is best to apply different cases and assumptions and see how they affect the company’s valuation. If a company grows at a different rate, or if its cost of equity or risk-free rate changes significantly, the result may look very different. Can we find out why the company is trading at a discount to intrinsic value? For Anhui Honglu Steel Construction (Group), we have compiled three other elements for you to look at:

1. Risks: You should be aware 3 warning signs for Anhui Honglu Steel Construction (Group) (1 is a bit concerning!) that we uncovered before considering investing in the company.
2. Future income: How does 002541’s growth rate compare to competitors and the overall market? Learn more about analyst consensus numbers for the coming years by using our free chart of analyst growth expectations.
3. Other high-quality alternatives: Like a good all-rounder? Explore our interactive list of high-quality stocks to get a sense of what else you might be missing out on!

PS. Simply Wall St updates its DCF calculation for each Chinese stock daily, so if you want to find out the intrinsic value of another stock, just search here.

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This Simply Wall St article is of a general nature. We comment solely on historical data and analyst forecasts, using an unbiased methodology. Our articles do not constitute financial advice. It is not a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. Our goal is to provide you with long-term analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative materials. Simply Wall St does not hold any of the stocks mentioned.

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