Stock Analysis

An Intrinsic Calculation For Arrow Home Group Co., Ltd. (SZSE:001322) Suggests It's 40% Undervalued

SZSE:001322
Source: Shutterstock

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, Arrow Home Group fair value estimate is CN¥13.32
  • Arrow Home Group's CN¥7.99 share price signals that it might be 40% undervalued
  • Our fair value estimate is 74% higher than Arrow Home Group's analyst price target of CN¥7.64

Today we will run through one way of estimating the intrinsic value of Arrow Home Group Co., Ltd. (SZSE:001322) by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

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.

Check out our latest analysis for Arrow Home Group

Crunching The Numbers

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 begin with, we have to get estimates of 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

2025202620272028202920302031203220332034
Levered FCF (CN¥, Millions) CN¥326.0mCN¥475.9mCN¥594.6mCN¥703.4mCN¥799.4mCN¥882.5mCN¥954.2mCN¥1.02bCN¥1.07bCN¥1.12b
Growth Rate Estimate SourceAnalyst x2Analyst x2Est @ 24.94%Est @ 18.30%Est @ 13.65%Est @ 10.39%Est @ 8.12%Est @ 6.52%Est @ 5.40%Est @ 4.62%
Present Value (CN¥, Millions) Discounted @ 8.9% CN¥299CN¥401CN¥460CN¥500CN¥522CN¥529CN¥525CN¥514CN¥497CN¥477

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥4.7b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 2.8%. We discount the terminal cash flows to today's value at a cost of equity of 8.9%.

Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = CN¥1.1b× (1 + 2.8%) ÷ (8.9%– 2.8%) = CN¥19b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥19b÷ ( 1 + 8.9%)10= CN¥8.0b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is CN¥13b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of CN¥8.0, the company appears quite good value at a 40% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf
SZSE:001322 Discounted Cash Flow January 14th 2025

Important 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 Arrow Home Group 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 8.9%, which is based on a levered beta of 1.227. 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 Arrow Home Group

Strength
  • Debt is well covered by earnings.
Weakness
  • Earnings declined over the past year.
  • Dividend is low compared to the top 25% of dividend payers in the Building market.
Opportunity
  • Annual earnings are forecast to grow faster than the Chinese market.
  • Trading below our estimate of fair value by more than 20%.
Threat
  • Debt is not well covered by operating cash flow.
  • Paying a dividend but company has no free cash flows.
  • Annual revenue is forecast to grow slower than the Chinese market.

Looking Ahead:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Arrow Home Group, there are three relevant aspects you should consider:

  1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Arrow Home Group , and understanding these should be part of your investment process.
  2. Future Earnings: How does 001322'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.
  3. 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!

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.

New: Manage All Your Stock Portfolios in One Place

We've created the ultimate portfolio companion for stock investors, and it's free.

• Connect an unlimited number of Portfolios and see your total in one currency
• Be alerted to new Warning Signs or Risks via email or mobile
• Track the Fair Value of your stocks

Try a Demo Portfolio for Free

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.