China Literature Limited (HKG:772) Shares Could Be 49% Below Their Intrinsic Value Estimate

Key Insights

• China Literature's estimated fair value is CN¥80.2 based on 2 Stage Free Cash Flow to Equity
• Current share price of CN¥40.9 suggests China Literature is 49% undervalued
• Analyst price target for 772 is CN¥45.82 which is 43% below our fair value estimate

Today we will run through one way of estimating the intrinsic value of China Literature Limited (HKG:772) by taking the forecast future cash flows of the company and discounting them back to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. 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. 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 China Literature

Step By Step Through The Calculation

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. 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, 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) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (CN¥, Millions)	CN¥1.19b	CN¥1.92b	CN¥2.68b	CN¥3.26b	CN¥3.77b	CN¥4.20b	CN¥4.56b	CN¥4.86b	CN¥5.10b	CN¥5.30b
Growth Rate Estimate Source	Analyst x4	Analyst x3	Analyst x1	Est @ 21.75%	Est @ 15.71%	Est @ 11.49%	Est @ 8.53%	Est @ 6.45%	Est @ 5.00%	Est @ 3.99%
Present Value (CN¥, Millions) Discounted @ 7.3%	CN¥1.1k	CN¥1.7k	CN¥2.2k	CN¥2.5k	CN¥2.6k	CN¥2.7k	CN¥2.8k	CN¥2.8k	CN¥2.7k	CN¥2.6k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥24b

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 (1.6%) 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 7.3%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = CN¥5.3b× (1 + 1.6%) ÷ (7.3%– 1.6%) = CN¥94b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥94b÷ ( 1 + 7.3%)¹⁰= CN¥46b

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¥70b. 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$40.9, the company appears quite undervalued at a 49% discount to where the stock price trades currently. 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. 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 Literature 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 7.3%, which is based on a levered beta of 0.817. 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 Literature

Looking Ahead:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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. Why is the intrinsic value higher than the current share price? For China Literature, we've put together three further items you should consider:

1. Risks: Every company has them, and we've spotted 1 warning sign for China Literature you should know about.
2. Future Earnings: How does 772'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. 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.