Are Investors Undervaluing ENN Energy Holdings Limited (HKG:2688) By 41%?

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of ENN Energy Holdings Limited (HKG:2688) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

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 still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

See our latest analysis for ENN Energy Holdings

Is ENN Energy Holdings fairly valued?

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

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (CN¥, Millions)	CN¥3.19b	CN¥4.61b	CN¥5.87b	CN¥7.52b	CN¥8.81b	CN¥9.74b	CN¥10.5b	CN¥11.1b	CN¥11.6b	CN¥12.1b
Growth Rate Estimate Source	Analyst x8	Analyst x9	Analyst x7	Analyst x3	Analyst x3	Est @ 10.59%	Est @ 7.86%	Est @ 5.94%	Est @ 4.6%	Est @ 3.67%
Present Value (CN¥, Millions) Discounted @ 5.8%	CN¥3.0k	CN¥4.1k	CN¥5.0k	CN¥6.0k	CN¥6.6k	CN¥6.9k	CN¥7.1k	CN¥7.1k	CN¥7.0k	CN¥6.9k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥60b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 5.8%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = CN¥12b× (1 + 1.5%) ÷ (5.8%– 1.5%) = CN¥283b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥283b÷ ( 1 + 5.8%)¹⁰= CN¥161b

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¥221b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of HK$140, the company appears quite good value at a 41% 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.

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 ENN Energy 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 5.8%, which is based on a levered beta of 0.800. 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.

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it 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. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For ENN Energy Holdings, we've compiled three further elements you should explore:

1. Risks: You should be aware of the 1 warning sign for ENN Energy Holdings we've uncovered before considering an investment in the company.
2. Future Earnings: How does 2688'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.

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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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