Weichai Power Co., Ltd.'s (HKG:2338) Intrinsic Value Is Potentially 100% Above Its Share Price

Key Insights

• Weichai Power's estimated fair value is CN¥24.3 based on 2 Stage Free Cash Flow to Equity
• Current share price of CN¥12.1 suggests Weichai Power is 50% undervalued
• Analyst price target for 2338 is CN¥14.28 which is 41% below our fair value estimate

Today we will run through one way of estimating the intrinsic value of Weichai Power Co., Ltd. (HKG:2338) by taking the forecast future cash flows of the company and discounting them back to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

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.

View our latest analysis for Weichai Power

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. 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.

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) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (CN¥, Millions)	CN¥10.7b	CN¥13.0b	CN¥14.6b	CN¥16.0b	CN¥17.1b	CN¥18.0b	CN¥18.8b	CN¥19.4b	CN¥20.0b	CN¥20.5b
Growth Rate Estimate Source	Analyst x2	Analyst x2	Est @ 12.64%	Est @ 9.33%	Est @ 7.02%	Est @ 5.40%	Est @ 4.27%	Est @ 3.47%	Est @ 2.92%	Est @ 2.53%
Present Value (CN¥, Millions) Discounted @ 11%	CN¥9.7k	CN¥10.6k	CN¥10.8k	CN¥10.7k	CN¥10.3k	CN¥9.8k	CN¥9.3k	CN¥8.7k	CN¥8.1k	CN¥7.5k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥95b

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 1.6%. We discount the terminal cash flows to today's value at a cost of equity of 11%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = CN¥21b× (1 + 1.6%) ÷ (11%– 1.6%) = CN¥232b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥232b÷ ( 1 + 11%)¹⁰= CN¥85b

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¥180b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of HK$12.1, the company appears quite undervalued at a 50% 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 Weichai Power 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 1.283. 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 Weichai Power

Looking Ahead:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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. Can we work out why the company is trading at a discount to intrinsic value? For Weichai Power, we've compiled three fundamental factors you should explore:

1. Risks: Case in point, we've spotted 2 warning signs for Weichai Power you should be aware of.
2. Future Earnings: How does 2338'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 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!

PS. Simply Wall St updates its DCF calculation for every Hong Kong 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.