SINOPEC Engineering (Group) Co., Ltd.'s (HKG:2386) Intrinsic Value Is Potentially 24% Below Its Share Price

How far off is SINOPEC Engineering (Group) Co., Ltd. (HKG:2386) 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. We will use the Discounted Cash Flow (DCF) model on this occasion. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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. 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 SINOPEC Engineering (Group)

Is SINOPEC Engineering (Group) fairly valued?

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. To begin with, we have to get estimates of 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.

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

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (CN¥, Millions)	CN¥1.57b	CN¥1.15b	CN¥937.4m	CN¥820.6m	CN¥752.7m	CN¥712.4m	CN¥688.9m	CN¥676.0m	CN¥670.2m	CN¥669.1m
Growth Rate Estimate Source	Est @ -39.17%	Est @ -26.97%	Est @ -18.44%	Est @ -12.46%	Est @ -8.28%	Est @ -5.35%	Est @ -3.3%	Est @ -1.87%	Est @ -0.86%	Est @ -0.16%
Present Value (CN¥, Millions) Discounted @ 7.2%	CN¥1.5k	CN¥1.0k	CN¥762	CN¥622	CN¥533	CN¥471	CN¥425	CN¥389	CN¥360	CN¥335

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥6.4b

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 7.2%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = CN¥669m× (1 + 1.5%) ÷ (7.2%– 1.5%) = CN¥12b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥12b÷ ( 1 + 7.2%)¹⁰= CN¥6.0b

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¥12b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of HK$4.4, the company appears reasonably expensive 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

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 SINOPEC Engineering (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 7.2%, which is based on a levered beta of 1.051. 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:

Although the valuation of a company is important, it 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. 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 lower than the current share price? For SINOPEC Engineering (Group), there are three additional factors you should further examine:

1. Risks: Be aware that SINOPEC Engineering (Group) is showing 1 warning sign in our investment analysis , you should know about...
2. Future Earnings: How does 2386'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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