Key Insights

• China Feihe's estimated fair value is HK$7.99 based on 2 Stage Free Cash Flow to Equity

• China Feihe's HK$4.85 share price signals that it might be 39% undervalued

• The CN¥5.72 analyst price target for 6186 is 28% less than our estimate of fair value

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of China Feihe Limited (HKG:6186) as an investment opportunity  by taking the forecast future cash flows of the company and discounting them back to today's value.  The Discounted Cash Flow (DCF) model is the tool we will apply to do this.  Believe it or not, it's not too difficult to follow, as you'll see from our example!

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws.  For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

See our latest analysis for China Feihe

The Calculation

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate.  To start off with, we need to estimate 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,  and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥27b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 6.8%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = CN¥3.7b× (1 + 2.0%) ÷ (6.8%– 2.0%) = CN¥78b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥78b÷ ( 1 + 6.8%)10= CN¥40b

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¥68b.  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$4.9, the company appears   quite undervalued    at a 39% 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.

SEHK:6186 Discounted Cash Flow November 15th 2023

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 China Feihe 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 6.8%, 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.

SWOT Analysis for China Feihe

Strength

• Debt is not viewed as a risk.

• Dividends are covered by earnings and cash flows.

• Dividend information for 6186.

Weakness

• Earnings declined over the past year.

• Dividend is low compared to the top 25% of dividend payers in the Food market.

Opportunity

• Annual earnings are forecast to grow for the next 3 years.

• Good value based on P/E ratio and estimated fair value.

Threat

• Annual earnings are forecast to grow slower than the Hong Kong market.

• What else are analysts forecasting for 6186?

Looking Ahead:

Although the valuation of a company is important, it  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.  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 example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation.   Why is the intrinsic value higher than the current share price?   For China Feihe, we've compiled three  important  aspects  you should explore:

1. Risks: Case in point, we've spotted   1 warning sign for China Feihe  you should be aware of.  

2. Future Earnings: How does 6186'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.