Zhejiang Expressway Co., Ltd.'s (HKG:576) Intrinsic Value Is Potentially 42% Above Its Share Price

Today we will run through one way of estimating the intrinsic value of Zhejiang Expressway Co., Ltd. (HKG:576) by estimating the company's future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Believe it or not, it's not too difficult to follow, as you'll see from our example!

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

The model

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, 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

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (CN¥, Millions)	CN¥9.53b	CN¥6.95b	CN¥5.58b	CN¥4.83b	CN¥4.40b	CN¥4.15b	CN¥4.00b	CN¥3.92b	CN¥3.88b	CN¥3.87b
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ -19.73%	Est @ -13.36%	Est @ -8.9%	Est @ -5.78%	Est @ -3.59%	Est @ -2.06%	Est @ -0.99%	Est @ -0.24%
Present Value (CN¥, Millions) Discounted @ 14%	CN¥8.4k	CN¥5.3k	CN¥3.8k	CN¥2.9k	CN¥2.3k	CN¥1.9k	CN¥1.6k	CN¥1.4k	CN¥1.2k	CN¥1.0k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥30b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (1.5%) 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 14%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = CN¥3.9b× (1 + 1.5%) ÷ (14%– 1.5%) = CN¥31b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥31b÷ ( 1 + 14%)¹⁰= CN¥8.4b

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¥38b. 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$7.4, the company appears a touch undervalued at a 30% 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.

The 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 Zhejiang Expressway 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 14%, which is based on a levered beta of 2.000. 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:

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. 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 Zhejiang Expressway, there are three additional elements you should consider:

1. Risks: To that end, you should learn about the 2 warning signs we've spotted with Zhejiang Expressway (including 1 which is potentially serious) .
2. Future Earnings: How does 576'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the SEHK every day. If you want to find the calculation for other stocks just search here.

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This article by Simply Wall St is general in nature. 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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