A Look At The Fair Value Of China MeiDong Auto Holdings Limited (HKG:1268)

Key Insights

• The projected fair value for China MeiDong Auto Holdings is HK$2.16 based on 2 Stage Free Cash Flow to Equity
• China MeiDong Auto Holdings' HK$1.80 share price indicates it is trading at similar levels as its fair value estimate
• Analyst price target for 1268 is CN¥2.25, which is 4.3% above our fair value estimate

Today we will run through one way of estimating the intrinsic value of China MeiDong Auto Holdings Limited (HKG:1268) 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. It may sound complicated, but actually it is quite simple!

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

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The Method

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 start off with, we need to estimate the next ten years of cash flows. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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) forecast

	2026	2027	2028	2029	2030	2031	2032	2033	2034	2035
Levered FCF (CN¥, Millions)	CN¥307.2m	CN¥280.4m	CN¥265.5m	CN¥257.8m	CN¥254.6m	CN¥254.5m	CN¥256.5m	CN¥259.9m	CN¥264.5m	CN¥269.8m
Growth Rate Estimate Source	Est @ -13.62%	Est @ -8.73%	Est @ -5.30%	Est @ -2.91%	Est @ -1.23%	Est @ -0.05%	Est @ 0.77%	Est @ 1.35%	Est @ 1.75%	Est @ 2.03%
Present Value (CN¥, Millions) Discounted @ 11%	CN¥276	CN¥226	CN¥192	CN¥168	CN¥149	CN¥133	CN¥121	CN¥110	CN¥100	CN¥92.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥1.6b

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. 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 (2.7%) 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 11%.

Terminal Value (TV)= FCF₂₀₃₅ × (1 + g) ÷ (r – g) = CN¥270m× (1 + 2.7%) ÷ (11%– 2.7%) = CN¥3.2b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥3.2b÷ ( 1 + 11%)¹⁰= CN¥1.1b

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¥2.7b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of HK$1.8, the company appears about fair value at a 17% 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.

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 MeiDong Auto 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 11%, which is based on a levered beta of 1.651. 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.

See our latest analysis for China MeiDong Auto Holdings

SWOT Analysis for China MeiDong Auto Holdings

Looking Ahead:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. 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. For China MeiDong Auto Holdings, there are three fundamental aspects you should further research:

1. Risks: You should be aware of the 1 warning sign for China MeiDong Auto Holdings we've uncovered before considering an investment in the company.
2. Future Earnings: How does 1268'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. 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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.