How far is Li Ning Company Limited (HKG: 2331) from its intrinsic value? Using the most recent financial data, we’ll examine whether the stock price is fair by estimating the company’s future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Believe it or not, it’s not too hard to follow, as you will see in our example!
We generally think of a business’s value as the present value of all the cash it will generate in the future. However, a DCF is only one evaluation measure among many, and it is not without its flaws. If you still have burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
See our latest analysis for Li Ning
Crunch the numbers
We use what is called a two-step model, which simply means that we have two different periods of growth rate for the cash flow of the business. Usually the first stage is higher growth and the second stage is lower growth stage. To begin with, we need to get cash flow estimates for the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated value. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we need to discount the sum of these future cash flows to arrive at an estimate of the present value:
10-year Free Cash Flow (FCF) estimate
|Leverage FCF (CN ¥, Million)||CN ¥ 4.51b||CN ¥ 5.71b||CN ¥ 6.94b||CN ¥ 7.87b||CN ¥ 8.55b||CN ¥ 9.10b||CN ¥ 9.55b||CN ¥ 9.93b||CN ¥ 10.2b||CN ¥ 10.5b|
|Source of estimated growth rate||Analyst x12||Analyst x11||Analyst x4||Analyst x3||East @ 8.6%||Est @ 6.46%||Est @ 4.97%||Est @ 3.92%||Est @ 3.19%||East @ 2.68%|
|Present value (CN ¥, million) discounted at 7.1%||CN ¥ 4.2k||CN ¥ 5.0k||CN ¥ 5.7k||CN ¥ 6.0k||CN ¥ 6.1k||CN ¥ 6.0k||CN ¥ 5.9k||CN ¥ 5.8k||CN ¥ 5.5k||CN ¥ 5.3k|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = CN ¥ 56b
After calculating the present value of future cash flows over the initial 10 year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first step. The Gordon growth formula is used to calculate the 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 their present value at a cost of equity of 7.1%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = CN ¥ 11b × (1 + 1.5%) ÷ (7.1% – 1.5%) = CN ¥ 192b
Present value of terminal value (PVTV)= TV / (1 + r)ten= CN ¥ 192b ÷ (1 + 7.1%)ten= CN ¥ 97b
Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is CN ¥ 152b. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current price of HK $ 98.3, the company looks potentially overvalued at the time of writing. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.
The above calculation is very dependent on two assumptions. One is the discount rate and the other is cash flow. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play with them. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a full picture of a company’s potential performance. Since we view Li Ning as a potential shareholder, the cost of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) which takes debt into account. In this calculation, we used 7.1%, which is based on a leveraged beta of 1.032. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
While important, calculating DCF ideally won’t be the only piece of analysis you’ll look at for a business. The DCF model is not a perfect equity valuation tool. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. Can we understand why the company is trading at a premium over intrinsic value? For Li Ning, we’ve put together three essentials you should explore:
- Risks: To do this, you need to know the 2 warning signs we spotted with Li Ning.
- Management: Have insiders increased their stocks to take advantage of market sentiment regarding 2331’s future outlook? Check out our management and board analysis with information on CEO compensation and governance factors.
- Other strong companies: 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 trading fundamentals to see if there are other companies you may not have considered!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for each SEHK share. If you want to find the calculation for other actions, just search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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