AviChina Industry & Technology Company Limited (HKG:2357) Shares Could Be 25% Below Their Intrinsic Value Estimate

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, AviChina Industry & Technology fair value estimate is HK$5.45
• Current share price of HK$4.06 suggests AviChina Industry & Technology is potentially 25% undervalued
• Our fair value estimate is 13% lower than AviChina Industry & Technology's analyst price target of CN¥6.25

How far off is AviChina Industry & Technology Company Limited (HKG:2357) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by projecting its future cash flows and then discounting them 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. 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 AviChina Industry & Technology

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. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (CN¥, Millions)	-CN¥614.0m	CN¥1.39b	CN¥1.86b	CN¥2.23b	CN¥2.54b	CN¥2.81b	CN¥3.02b	CN¥3.21b	CN¥3.36b	CN¥3.48b
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x2	Est @ 19.43%	Est @ 14.12%	Est @ 10.41%	Est @ 7.81%	Est @ 5.99%	Est @ 4.71%	Est @ 3.82%
Present Value (CN¥, Millions) Discounted @ 8.5%	-CN¥566	CN¥1.2k	CN¥1.5k	CN¥1.6k	CN¥1.7k	CN¥1.7k	CN¥1.7k	CN¥1.7k	CN¥1.6k	CN¥1.5k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥14b

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 1.7%. We discount the terminal cash flows to today's value at a cost of equity of 8.5%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = CN¥3.5b× (1 + 1.7%) ÷ (8.5%– 1.7%) = CN¥52b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥52b÷ ( 1 + 8.5%)¹⁰= CN¥23b

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¥37b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of HK$4.1, the company appears a touch undervalued at a 25% 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

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 AviChina Industry & Technology 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 8.5%, which is based on a levered beta of 0.944. 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 AviChina Industry & Technology

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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 AviChina Industry & Technology, there are three fundamental aspects you should look at:

1. Financial Health: Does 2357 have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
2. Future Earnings: How does 2357'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. 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. 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.