Calculating The Fair Value Of Shanghai STEP Electric Corporation (SZSE:002527)

Key Insights

• The projected fair value for Shanghai STEP Electric is CN¥6.95 based on 2 Stage Free Cash Flow to Equity
• With CN¥8.24 share price, Shanghai STEP Electric appears to be trading close to its estimated fair value
• Industry average of 1,820% suggests Shanghai STEP Electric's peers are currently trading at a higher premium to fair value

Does the April share price for Shanghai STEP Electric Corporation (SZSE:002527) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the forecast future cash flows of the company and discounting them back to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

View our latest analysis for Shanghai STEP Electric

Is Shanghai STEP Electric Fairly Valued?

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To begin with, we have to get estimates of 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.

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) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CN¥, Millions)	CN¥271.5m	CN¥290.8m	CN¥307.7m	CN¥323.0m	CN¥337.1m	CN¥350.4m	CN¥363.1m	CN¥375.6m	CN¥387.9m	CN¥400.2m
Growth Rate Estimate Source	Est @ 8.86%	Est @ 7.08%	Est @ 5.84%	Est @ 4.97%	Est @ 4.36%	Est @ 3.94%	Est @ 3.64%	Est @ 3.43%	Est @ 3.28%	Est @ 3.18%
Present Value (CN¥, Millions) Discounted @ 9.5%	CN¥248	CN¥242	CN¥234	CN¥225	CN¥214	CN¥203	CN¥192	CN¥182	CN¥171	CN¥161

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥2.1b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (2.9%) 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 9.5%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CN¥400m× (1 + 2.9%) ÷ (9.5%– 2.9%) = CN¥6.3b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥6.3b÷ ( 1 + 9.5%)¹⁰= CN¥2.5b

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¥4.6b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of CN¥8.2, 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.

Important Assumptions

We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual 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 Shanghai STEP Electric 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 9.5%, which is based on a levered beta of 1.168. 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 Shanghai STEP Electric

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching 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. For Shanghai STEP Electric, there are three fundamental aspects you should look at:

1. Risks: Take risks, for example - Shanghai STEP Electric has 1 warning sign we think 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.