Calculating The Intrinsic Value Of AAC Technologies Holdings Inc. (HKG:2018)

Today we will run through one way of estimating the intrinsic value of AAC Technologies Holdings Inc. (HKG:2018) by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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.

See our latest analysis for AAC Technologies Holdings

Is AAC Technologies Holdings fairly valued?

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 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.

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) forecast

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (CN¥, Millions)	CN¥2.16b	CN¥2.93b	CN¥2.09b	CN¥2.43b	CN¥2.44b	CN¥2.46b	CN¥2.49b	CN¥2.51b	CN¥2.54b	CN¥2.58b
Growth Rate Estimate Source	Analyst x8	Analyst x8	Analyst x2	Analyst x1	Est @ 0.4%	Est @ 0.73%	Est @ 0.95%	Est @ 1.11%	Est @ 1.22%	Est @ 1.3%
Present Value (CN¥, Millions) Discounted @ 8.1%	CN¥2.0k	CN¥2.5k	CN¥1.7k	CN¥1.8k	CN¥1.7k	CN¥1.5k	CN¥1.4k	CN¥1.3k	CN¥1.3k	CN¥1.2k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥16b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.5%. We discount the terminal cash flows to today's value at a cost of equity of 8.1%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = CN¥2.6b× (1 + 1.5%) ÷ (8.1%– 1.5%) = CN¥40b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥40b÷ ( 1 + 8.1%)¹⁰= CN¥18b

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¥35b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of HK$34.4, the company appears about fair value at a 1.2% 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.

Important 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 AAC Technologies 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 8.1%, which is based on a levered beta of 1.331. 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:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize 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. For AAC Technologies Holdings, we've put together three further aspects you should further research:

1. Risks: We feel that you should assess the 2 warning signs for AAC Technologies Holdings we've flagged before making an investment in the company.
2. Future Earnings: How does 2018'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.

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.

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