Estimating The Intrinsic Value Of Shenzhen AOTO Electronics Co., Ltd. (SZSE:002587)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Shenzhen AOTO Electronics fair value estimate is CN¥5.98
• Shenzhen AOTO Electronics' CN¥5.91 share price indicates it is trading at similar levels as its fair value estimate
• Peers of Shenzhen AOTO Electronics are currently trading on average at a 687% premium

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Shenzhen AOTO Electronics Co., Ltd. (SZSE:002587) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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 Shenzhen AOTO Electronics

The Model

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 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (CN¥, Millions)	CN¥38.9m	CN¥67.4m	CN¥102.4m	CN¥140.5m	CN¥178.3m	CN¥213.4m	CN¥244.7m	CN¥271.9m	CN¥295.3m	CN¥315.7m
Growth Rate Estimate Source	Est @ 103.07%	Est @ 73.00%	Est @ 51.96%	Est @ 37.23%	Est @ 26.91%	Est @ 19.69%	Est @ 14.64%	Est @ 11.10%	Est @ 8.63%	Est @ 6.89%
Present Value (CN¥, Millions) Discounted @ 8.2%	CN¥36.0	CN¥57.6	CN¥80.9	CN¥103	CN¥120	CN¥133	CN¥141	CN¥145	CN¥146	CN¥144

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥1.1b

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 8.2%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = CN¥316m× (1 + 2.9%) ÷ (8.2%– 2.9%) = CN¥6.1b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥6.1b÷ ( 1 + 8.2%)¹⁰= CN¥2.8b

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¥3.9b. 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¥5.9, the company appears about fair value at a 1.2% discount to where the stock price trades currently. 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

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Shenzhen AOTO Electronics 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 8.2%, which is based on a levered beta of 1.068. 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 Shenzhen AOTO Electronics

Moving On:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Shenzhen AOTO Electronics, we've compiled three relevant factors you should further research:

1. Risks: We feel that you should assess the 2 warning signs for Shenzhen AOTO Electronics we've flagged before making an investment in the company.
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.