Is AAC Technologies Holdings Inc. (HKG:2018) Trading At A 42% Discount?

Key Insights

• The projected fair value for AAC Technologies Holdings is HK$32.39 based on 2 Stage Free Cash Flow to Equity
• AAC Technologies Holdings' HK$18.84 share price signals that it might be 42% undervalued
• Our fair value estimate is 88% higher than AAC Technologies Holdings' analyst price target of CN¥17.25

In this article we are going to estimate the intrinsic value of AAC Technologies Holdings Inc. (HKG:2018) by taking the forecast future cash flows of the company and discounting them back to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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 AAC Technologies Holdings

The Model

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CN¥, Millions)	CN¥2.67b	CN¥2.67b	CN¥2.94b	CN¥3.05b	CN¥3.15b	CN¥3.24b	CN¥3.33b	CN¥3.41b	CN¥3.49b	CN¥3.57b
Growth Rate Estimate Source	Analyst x4	Analyst x5	Analyst x1	Est @ 3.91%	Est @ 3.33%	Est @ 2.92%	Est @ 2.64%	Est @ 2.44%	Est @ 2.30%	Est @ 2.20%
Present Value (CN¥, Millions) Discounted @ 10%	CN¥2.4k	CN¥2.2k	CN¥2.2k	CN¥2.1k	CN¥2.0k	CN¥1.8k	CN¥1.7k	CN¥1.6k	CN¥1.5k	CN¥1.4k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥19b

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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 10%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CN¥3.6b× (1 + 2.0%) ÷ (10%– 2.0%) = CN¥45b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥45b÷ ( 1 + 10%)¹⁰= CN¥17b

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¥36b. 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$18.8, the company appears quite undervalued at a 42% 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 10%, 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.

SWOT Analysis for AAC Technologies Holdings

Looking Ahead:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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 AAC Technologies Holdings, there are three fundamental aspects you should look at:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with AAC Technologies Holdings , and understanding this should be part of your investment process.
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 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.