Calculation of the intrinsic value of Henan Zhongyuan Expressway Company Limited (SHSE:600020)

Key findings

• Using the 2-step free cash flow to equity, the estimated fair value of Henan Zhongyuan Expressway is CN¥3.41.
• The current share price of CNY 3.66 suggests that Henan Zhongyuan Expressway may be trading close to its fair value.
• Compared to the industry average discount of -189%, Henan Zhongyuan Expressway’s competitors appear to be trading at a higher premium to fair value

In this article, we will estimate the intrinsic value of Henan Zhongyuan Expressway Company Limited (SHSE:600020) by estimating the company’s future cash flows and discounting them to their present value using the discounted cash flow (DCF) model. This may sound complicated, but it’s actually quite simple!

We would like to point out that there are many ways to value a company and that each method, like the DCF, has advantages and disadvantages in certain scenarios. If you still have questions about this type of valuation, take a look at Simply Wall St’s analysis model.

Check out our latest analysis for Henan Zhongyuan Expressway

The method

We will use a two-stage DCF model which, as the name suggests, takes into account two phases of growth. The first stage is generally a higher growth phase that stabilizes towards the terminal value captured in the second “steady growth” stage. First, we need to obtain estimates of the next ten years of cash flows. Since we don’t have analyst estimates of free cash flow available, we extrapolated the previous free cash flow (FCF) from the company’s last 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 account for the fact that growth tends to slow more in the early years than in later years.

In general, we assume that a dollar today is worth more than a dollar in the future. Therefore, we discount the value of these future cash flows to their estimated value in today’s dollars:

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) = 4.8 billion CNY

After calculating the present value of future cash flows in the first 10-year period, we need to calculate the terminal value that takes into account all future cash flows after the first 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 using a cost of equity of 14%.

Final value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = CN¥1.2b × (1 + 2.9%) ÷ (14% – 2.9%) = CN¥11b

Present value of terminal value (PVTV)= TV / (1 + r)¹⁰= CN¥11b÷ ( 1 + 14 %)¹⁰= 2.9 billion CNY

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 CN¥7.7 billion. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of CN¥3.7, the company seems about fair at the time of writing. 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. If you disagree with these results, try the calculation yourself and play with the 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 view Henan Zhongyuan Expressway 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 takes debt into account. In this calculation, we used 14%, which is based on a levered beta of 2,000. Beta is a measure of a stock’s volatility relative to the overall market. 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 Henan Zhongyuan Expressway

Go on:

While a company’s valuation is important, it is only one of many factors you need to evaluate a company. DCF models are not the be-all and end-all of investment valuation. Rather, they should be viewed as a guide to “what assumptions need to hold for this stock to be under/overvalued.” For example, making a small adjustment to the terminal value growth rate can dramatically change the overall outcome. For Henan Zhongyuan Expressway, we have compiled three relevant factors for you to further investigate:

1. Risks: For example, we found 3 warning signs for the Henan Zhongyuan Expressway (2 make us uncomfortable!) that you need to consider before investing here.
2. 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!
3. Other environmentally friendly companies: Are you concerned about the environment and believe that consumers will increasingly buy environmentally friendly products? Browse through our interactive list of companies thinking about a greener future and discover some stocks you may not have thought of yet!

PS. The Simply Wall St app runs a discounted cash flow valuation for every stock on the SHSE every day. If you want to find the calculation for other stocks, 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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