Estimating The Intrinsic Value Of Huadian Energy Company Limited (SHSE:600726)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Huadian Energy fair value estimate is CN¥2.17
• Current share price of CN¥2.45 suggests Huadian Energy is potentially trading close to its fair value
• Industry average of 3,196% suggests Huadian Energy'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 Huadian Energy Company Limited (SHSE:600726) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Don't get put off by the jargon, the math behind it is actually quite straightforward.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

See our latest analysis for Huadian Energy

The Calculation

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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, 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) forecast

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (CN¥, Millions)	CN¥1.66b	CN¥1.27b	CN¥1.07b	CN¥966.5m	CN¥906.7m	CN¥875.0m	CN¥861.0m	CN¥858.6m	CN¥864.1m	CN¥875.2m
Growth Rate Estimate Source	Est @ -34.64%	Est @ -23.41%	Est @ -15.55%	Est @ -10.04%	Est @ -6.19%	Est @ -3.49%	Est @ -1.60%	Est @ -0.28%	Est @ 0.64%	Est @ 1.29%
Present Value (CN¥, Millions) Discounted @ 7.3%	CN¥1.5k	CN¥1.1k	CN¥869	CN¥728	CN¥636	CN¥572	CN¥525	CN¥487	CN¥457	CN¥431

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥7.4b

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 7.3%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = CN¥875m× (1 + 2.8%) ÷ (7.3%– 2.8%) = CN¥20b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥20b÷ ( 1 + 7.3%)¹⁰= CN¥9.8b

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¥17b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of CN¥2.5, 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. 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 Huadian Energy 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 7.3%, which is based on a levered beta of 0.911. 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:

Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess 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?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For Huadian Energy, we've compiled three important factors you should explore:

1. Risks: We feel that you should assess the 1 warning sign for Huadian Energy we've flagged before making an investment in the company.
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.