An Intrinsic Calculation For Dongfeng Motor Group Company Limited (HKG:489) Suggests It's 22% Undervalued

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Dongfeng Motor Group Company Limited (HKG:489) 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. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

View our latest analysis for Dongfeng Motor Group

Is Dongfeng Motor Group fairly valued?

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

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

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (CN¥, Millions)	-CN¥5.98b	-CN¥4.32b	CN¥13.3b	CN¥13.7b	CN¥14.0b	CN¥14.3b	CN¥14.6b	CN¥14.9b	CN¥15.1b	CN¥15.4b
Growth Rate Estimate Source	Analyst x5	Analyst x6	Analyst x1	Analyst x1	Est @ 2.43%	Est @ 2.16%	Est @ 1.96%	Est @ 1.83%	Est @ 1.73%	Est @ 1.67%
Present Value (CN¥, Millions) Discounted @ 14%	-CN¥5.2k	-CN¥3.3k	CN¥8.9k	CN¥8.1k	CN¥7.3k	CN¥6.5k	CN¥5.8k	CN¥5.2k	CN¥4.6k	CN¥4.1k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥42b

The second stage is also known as Terminal Value, this is the business's cash flow after 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 1.5%. We discount the terminal cash flows to today's value at a cost of equity of 14%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = CN¥15b× (1 + 1.5%) ÷ (14%– 1.5%) = CN¥125b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥125b÷ ( 1 + 14%)¹⁰= CN¥34b

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¥76b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of HK$8.2, the company appears a touch undervalued at a 22% 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.

The assumptions

Now 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 Dongfeng Motor Group 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 14%, which is based on a levered beta of 2.000. 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.

Looking Ahead:

Whilst important, the DCF calculation 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. 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. 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. Why is the intrinsic value higher than the current share price? For Dongfeng Motor Group, we've compiled three essential elements you should consider:

1. Risks: For example, we've discovered 4 warning signs for Dongfeng Motor Group (1 is potentially serious!) that you should be aware of before investing here.
2. Future Earnings: How does 489'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 SEHK 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. 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.
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