Are Investors Undervaluing Shoucheng Holdings Limited (HKG:697) By 46%?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Shoucheng Holdings fair value estimate is HK$3.47
• Shoucheng Holdings is estimated to be 46% undervalued based on current share price of HK$1.87
• Analyst price target for 697 is HK$2.40 which is 31% below our fair value estimate

In this article we are going to estimate the intrinsic value of Shoucheng Holdings Limited (HKG:697) by taking the forecast future cash flows of the company and discounting them back to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

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.

See our latest analysis for Shoucheng Holdings

The Method

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. 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) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (HK$, Millions)	HK$270.0m	HK$1.02b	HK$1.43b	HK$1.75b	HK$2.03b	HK$2.27b	HK$2.47b	HK$2.64b	HK$2.78b	HK$2.89b
Growth Rate Estimate Source	Analyst x1	Analyst x1	Analyst x1	Est @ 22.31%	Est @ 16.16%	Est @ 11.85%	Est @ 8.83%	Est @ 6.72%	Est @ 5.25%	Est @ 4.21%
Present Value (HK$, Millions) Discounted @ 9.7%	HK$246	HK$845	HK$1.1k	HK$1.2k	HK$1.3k	HK$1.3k	HK$1.3k	HK$1.3k	HK$1.2k	HK$1.1k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = HK$11b

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 (1.8%) 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 9.7%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = HK$2.9b× (1 + 1.8%) ÷ (9.7%– 1.8%) = HK$37b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= HK$37b÷ ( 1 + 9.7%)¹⁰= HK$15b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is HK$26b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of HK$1.9, the company appears quite undervalued at a 46% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

Important 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 Shoucheng 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 9.7%, which is based on a levered beta of 1.131. 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 Shoucheng Holdings

Looking Ahead:

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 example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Shoucheng Holdings, we've put together three relevant elements you should further research:

1. Risks: To that end, you should be aware of the 2 warning signs we've spotted with Shoucheng Holdings .
2. Future Earnings: How does 697'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.