Are Sany Heavy Equipment International Holdings Company Limited (HKG:631) Investors Paying Above The Intrinsic Value?

Today we will run through one way of estimating the intrinsic value of Sany Heavy Equipment International Holdings Company Limited (HKG:631) 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. Believe it or not, it's not too difficult to follow, as you'll see from our example!

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for Sany Heavy Equipment International Holdings

Is Sany Heavy Equipment International Holdings fairly valued?

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. 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

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (CN¥, Millions)	CN¥783.3m	CN¥831.3m	CN¥870.7m	CN¥903.4m	CN¥931.1m	CN¥955.3m	CN¥976.9m	CN¥996.7m	CN¥1.02b	CN¥1.03b
Growth Rate Estimate Source	Est @ 8.12%	Est @ 6.13%	Est @ 4.73%	Est @ 3.76%	Est @ 3.07%	Est @ 2.6%	Est @ 2.26%	Est @ 2.03%	Est @ 1.86%	Est @ 1.75%
Present Value (CN¥, Millions) Discounted @ 7.0%	CN¥732	CN¥726	CN¥711	CN¥690	CN¥665	CN¥638	CN¥610	CN¥581	CN¥554	CN¥527

("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. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (1.5%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 7.0%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = CN¥1.0b× (1 + 1.5%) ÷ (7.0%– 1.5%) = CN¥19b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥19b÷ ( 1 + 7.0%)¹⁰= CN¥9.7b

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¥16b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of HK$8.2, the company appears slightly overvalued 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

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Sany Heavy Equipment International Holdings 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 7.0%, which is based on a levered beta of 1.105. 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.

Moving On:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price exceeding the intrinsic value? For Sany Heavy Equipment International Holdings, we've compiled three pertinent factors you should explore:

1. Risks: For instance, we've identified 1 warning sign for Sany Heavy Equipment International Holdings that you should be aware of.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for 631's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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. 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.