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Is There An Opportunity With China East Education Holdings Limited's (HKG:667) 40% Undervaluation?
In this article we are going to estimate the intrinsic value of China East Education Holdings Limited (HKG:667) by taking the forecast future cash flows of the company and discounting them back to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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 China East Education Holdings
Crunching The Numbers
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. 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.
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¥737.0m | CN¥687.0m | CN¥853.0m | CN¥980.0m | CN¥1.06b | CN¥1.13b | CN¥1.18b | CN¥1.23b | CN¥1.27b | CN¥1.30b |
Growth Rate Estimate Source | Analyst x1 | Analyst x1 | Analyst x1 | Analyst x1 | Est @ 8.18% | Est @ 6.21% | Est @ 4.83% | Est @ 3.87% | Est @ 3.19% | Est @ 2.72% |
Present Value (CN¥, Millions) Discounted @ 7.4% | CN¥686 | CN¥595 | CN¥688 | CN¥736 | CN¥741 | CN¥733 | CN¥716 | CN¥692 | CN¥665 | CN¥636 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥6.9b
After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 (1.6%) 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 7.4%.
Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = CN¥1.3b× (1 + 1.6%) ÷ (7.4%– 1.6%) = CN¥23b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥23b÷ ( 1 + 7.4%)10= CN¥11b
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¥18b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of HK$5.5, the company appears quite good value at a 40% 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.
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 China East Education 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 7.4%, which is based on a levered beta of 0.894. 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 China East Education Holdings
- Earnings growth over the past year exceeded the industry.
- Currently debt free.
- Dividend is low compared to the top 25% of dividend payers in the Consumer Services market.
- Annual revenue is forecast to grow faster than the Hong Kong market.
- Trading below our estimate of fair value by more than 20%.
- Dividends are not covered by earnings.
- Annual earnings are forecast to grow slower than the Hong Kong market.
Next Steps:
Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. 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 China East Education Holdings, there are three essential factors you should further examine:
- Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with China East Education Holdings (at least 2 which are significant) , and understanding these should be part of your investment process.
- Future Earnings: How does 667'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.
- 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. 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.
About SEHK:667
China East Education Holdings
An investment holding company, provides vocational training education services in the People's Republic of China.
Flawless balance sheet with acceptable track record.