A Look At The Fair Value Of Qingdao Eastsoft Communication Technology Co.,Ltd (SZSE:300183)

Key Insights

• The projected fair value for Qingdao Eastsoft Communication TechnologyLtd is CN¥10.63 based on 2 Stage Free Cash Flow to Equity
• Current share price of CN¥11.35 suggests Qingdao Eastsoft Communication TechnologyLtd is potentially trading close to its fair value
• Industry average of 258% suggests Qingdao Eastsoft Communication TechnologyLtd's peers are currently trading at a higher premium to fair value

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Qingdao Eastsoft Communication Technology Co.,Ltd (SZSE:300183) as an investment opportunity by taking the expected future cash flows and 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!

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.

View our latest analysis for Qingdao Eastsoft Communication TechnologyLtd

Crunching The Numbers

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) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CN¥, Millions)	CN¥191.6m	CN¥217.4m	CN¥239.7m	CN¥259.1m	CN¥276.0m	CN¥291.0m	CN¥304.6m	CN¥317.2m	CN¥329.1m	CN¥340.7m
Growth Rate Estimate Source	Est @ 17.96%	Est @ 13.44%	Est @ 10.28%	Est @ 8.07%	Est @ 6.52%	Est @ 5.43%	Est @ 4.67%	Est @ 4.14%	Est @ 3.77%	Est @ 3.51%
Present Value (CN¥, Millions) Discounted @ 8.1%	CN¥177	CN¥186	CN¥190	CN¥190	CN¥187	CN¥183	CN¥177	CN¥171	CN¥164	CN¥157

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥1.8b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 8.1%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CN¥341m× (1 + 2.9%) ÷ (8.1%– 2.9%) = CN¥6.8b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥6.8b÷ ( 1 + 8.1%)¹⁰= CN¥3.1b

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¥4.9b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of CN¥11.4, the company appears around fair value at the time of writing. 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.

The 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 Qingdao Eastsoft Communication TechnologyLtd 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 8.1%, which is based on a levered beta of 0.915. 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.

Next Steps:

Whilst important, the DCF calculation 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. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Qingdao Eastsoft Communication TechnologyLtd, there are three fundamental factors you should further examine:

1. Risks: Be aware that Qingdao Eastsoft Communication TechnologyLtd is showing 3 warning signs in our investment analysis , and 1 of those doesn't sit too well with us...
2. Other Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!
3. Other Top Analyst Picks: Interested to see what the analysts are thinking? Take a look at our interactive list of analysts' top stock picks to find out what they feel might have an attractive future outlook!

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com