Is There An Opportunity With China Merchants Expressway Network & Technology Holdings Co.,Ltd.'s (SZSE:001965) 24% Undervaluation?

Key Insights

• China Merchants Expressway Network & Technology HoldingsLtd's estimated fair value is CN¥16.28 based on 2 Stage Free Cash Flow to Equity
• Current share price of CN¥12.35 suggests China Merchants Expressway Network & Technology HoldingsLtd is potentially 24% undervalued
• Our fair value estimate is 21% higher than China Merchants Expressway Network & Technology HoldingsLtd's analyst price target of CN¥13.51

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of China Merchants Expressway Network & Technology Holdings Co.,Ltd. (SZSE:001965) as an investment opportunity by estimating the company's future cash flows and discounting them to their present 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!

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.

View our latest analysis for China Merchants Expressway Network & Technology HoldingsLtd

What's The Estimated Valuation?

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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) forecast

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥57b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 11%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = CN¥13b× (1 + 2.8%) ÷ (11%– 2.8%) = CN¥158b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥158b÷ ( 1 + 11%)¹⁰= CN¥54b

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¥111b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of CN¥12.4, the company appears a touch undervalued at a 24% 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

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. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 China Merchants Expressway Network & Technology HoldingsLtd 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 11%, which is based on a levered beta of 1.722. 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 China Merchants Expressway Network & Technology HoldingsLtd

Next Steps:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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. Why is the intrinsic value higher than the current share price? For China Merchants Expressway Network & Technology HoldingsLtd, we've put together three important aspects you should look at:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with China Merchants Expressway Network & Technology HoldingsLtd (at least 1 which shouldn't be ignored) , and understanding them should be part of your investment process.
2. Future Earnings: How does 001965'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.

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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.