Shanghai Gench Education Group Limited (HKG:1525) Shares Could Be 52% Below Their Intrinsic Value Estimate

Today we will run through one way of estimating the intrinsic value of Shanghai Gench Education Group Limited (HKG:1525) by taking the expected future cash flows and discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. 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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Shanghai Gench Education Group

The method

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. 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.

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¥235.0m	CN¥265.1m	CN¥286.9m	CN¥304.6m	CN¥319.3m	CN¥331.4m	CN¥341.7m	CN¥350.8m	CN¥358.8m	CN¥366.2m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ 8.21%	Est @ 6.2%	Est @ 4.79%	Est @ 3.81%	Est @ 3.12%	Est @ 2.64%	Est @ 2.3%	Est @ 2.06%
Present Value (CN¥, Millions) Discounted @ 8.3%	CN¥217	CN¥226	CN¥226	CN¥221	CN¥214	CN¥205	CN¥195	CN¥185	CN¥175	CN¥165

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥2.0b

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 8.3%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = CN¥366m× (1 + 1.5%) ÷ (8.3%– 1.5%) = CN¥5.5b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥5.5b÷ ( 1 + 8.3%)¹⁰= CN¥2.4b

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¥4.5b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of HK$6.2, the company appears potentially underpriced at a discount of over 50%. This might sound concerning, and we recommend potential investors to dig deeper. What is going on here to cause the market to undervalue the stock so much? 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

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 Shanghai Gench Education 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 8.3%, which is based on a levered beta of 1.090. 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. 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. Can we work out why the company is trading at a discount to intrinsic value? For Shanghai Gench Education Group, we've put together three pertinent items you should further examine:

1. Risks: As an example, we've found 2 warning signs for Shanghai Gench Education Group that you need to consider before investing here.
2. Future Earnings: How does 1525'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. 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. 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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