A Look At The Fair Value Of Shanghai Lianming Machinery Co., Ltd. (SHSE:603006)

Key Insights

• The projected fair value for Shanghai Lianming Machinery is CN¥12.62 based on 2 Stage Free Cash Flow to Equity
• With CN¥14.64 share price, Shanghai Lianming Machinery appears to be trading close to its estimated fair value
• Shanghai Lianming Machinery's peers seem to be trading at a higher premium to fair value based onthe industry average of -3,579%

Today we will run through one way of estimating the intrinsic value of Shanghai Lianming Machinery Co., Ltd. (SHSE:603006) by taking the forecast future cash flows of the company and discounting them back to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. It may sound complicated, but actually it is quite simple!

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for Shanghai Lianming Machinery

The Model

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. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CN¥, Millions)	CN¥197.8m	CN¥209.6m	CN¥220.1m	CN¥229.8m	CN¥239.0m	CN¥247.7m	CN¥256.2m	CN¥264.7m	CN¥273.1m	CN¥281.6m
Growth Rate Estimate Source	Est @ 7.22%	Est @ 5.93%	Est @ 5.04%	Est @ 4.41%	Est @ 3.97%	Est @ 3.66%	Est @ 3.44%	Est @ 3.29%	Est @ 3.19%	Est @ 3.11%
Present Value (CN¥, Millions) Discounted @ 9.6%	CN¥181	CN¥174	CN¥167	CN¥159	CN¥151	CN¥143	CN¥135	CN¥127	CN¥120	CN¥113

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥1.5b

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 9.6%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CN¥282m× (1 + 2.9%) ÷ (9.6%– 2.9%) = CN¥4.4b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥4.4b÷ ( 1 + 9.6%)¹⁰= CN¥1.7b

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¥3.2b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of CN¥14.6, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Shanghai Lianming Machinery 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 9.6%, 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.

Moving On:

Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. 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 Shanghai Lianming Machinery, we've put together three essential aspects you should assess:

1. Risks: Case in point, we've spotted 2 warning signs for Shanghai Lianming Machinery you should be aware of.
2. Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
3. Other Environmentally-Friendly Companies: Concerned about the environment and think consumers will buy eco-friendly products more and more? Browse through our interactive list of companies that are thinking about a greener future to discover some stocks you may not have thought of!

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.

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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.