Estimating The Intrinsic Value Of Shanghai Aohua Photoelectricity Endoscope Co., Ltd. (SHSE:688212)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Shanghai Aohua Photoelectricity Endoscope fair value estimate is CN¥42.57
• Shanghai Aohua Photoelectricity Endoscope's CN¥41.31 share price indicates it is trading at similar levels as its fair value estimate
• Our fair value estimate is 26% lower than Shanghai Aohua Photoelectricity Endoscope's analyst price target of CN¥57.33

In this article we are going to estimate the intrinsic value of Shanghai Aohua Photoelectricity Endoscope Co., Ltd. (SHSE:688212) by projecting its future cash flows and then discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Shanghai Aohua Photoelectricity Endoscope

The Method

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. 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, 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) estimate

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (CN¥, Millions)	-CN¥105.0m	CN¥77.0m	CN¥121.2m	CN¥171.0m	CN¥221.5m	CN¥269.3m	CN¥312.3m	CN¥349.8m	CN¥382.2m	CN¥410.3m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ 57.41%	Est @ 41.04%	Est @ 29.58%	Est @ 21.56%	Est @ 15.95%	Est @ 12.02%	Est @ 9.27%	Est @ 7.34%
Present Value (CN¥, Millions) Discounted @ 7.5%	-CN¥97.7	CN¥66.6	CN¥97.6	CN¥128	CN¥154	CN¥175	CN¥188	CN¥196	CN¥200	CN¥199

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥1.3b

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 2.9%. We discount the terminal cash flows to today's value at a cost of equity of 7.5%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = CN¥410m× (1 + 2.9%) ÷ (7.5%– 2.9%) = CN¥9.1b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥9.1b÷ ( 1 + 7.5%)¹⁰= CN¥4.4b

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¥5.7b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of CN¥41.3, the company appears about fair value at a 3.0% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

Important Assumptions

Now 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 Aohua Photoelectricity Endoscope 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 7.5%, which is based on a levered beta of 0.931. 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 Aohua Photoelectricity Endoscope

Moving On:

Although the valuation of a company is important, 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 Aohua Photoelectricity Endoscope, there are three further factors you should explore:

1. Risks: You should be aware of the 4 warning signs for Shanghai Aohua Photoelectricity Endoscope (3 are a bit concerning!) we've uncovered before considering an investment in the company.
2. Future Earnings: How does 688212'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. The Simply Wall St app conducts 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 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.