I use what is known as a 2-stage model, which simply means we have two different periods of varying growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a more stable growth phase. To begin with we have to get estimates of the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. The sum of these cash flows is then discounted to today’s value.
5-year cash flow estimate
|Levered FCF (CN¥, Millions)||CN¥392.00||CN¥303.00||CN¥445.00||CN¥635.00||CN¥322.00|
|Source||Analyst x1||Analyst x2||Analyst x2||Analyst x1||Analyst x1|
|Present Value Discounted @ 8.96%||CN¥359.76||CN¥255.22||CN¥344.00||CN¥450.51||CN¥209.66|
Present Value of 5-year Cash Flow (PVCF)= CN¥1.62b
After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 2.9%. We discount this to today’s value at a cost of equity of 9%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = CN¥322.00m × (1 + 2.9%) ÷ (9% – 2.9%) = CN¥5.52b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = CN¥5.52b ÷ ( 1 + 9%)5 = CN¥3.59b
The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is CN¥5.21b. To get the intrinsic value per share, we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR. This results in an intrinsic value in the company’s reported currency of CN¥86.63. However, HMI’s primary listing is in China, and 1 share of HMI in CNY represents 0.150 ( CNY/ USD) share of NYSE:HMI, so the intrinsic value per share in USD is $12.97. Compared to the current share price of $9.43, the stock is about right, perhaps slightly undervalued at a 27.30% discount to what it is available for right now.
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. If you don’t agree with my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Huami as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 9%, which is based on a levered beta of 0.853. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For HMI, I’ve put together three important aspects you should further examine:
- Financial Health: Does HMI have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does HMI’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.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of HMI? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. The Simply Wall St app conducts a discounted cash flow for every stock on the NYSE every 6 hours. If you want to find the calculation for other stocks just search here.