Are Investors Undervaluing Zhongmin Energy Co., Ltd. (SHSE:600163) By 40%?

Simply Wall St · 10/15 22:20

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, Zhongmin Energy fair value estimate is CN¥8.44
  • Zhongmin Energy's CN¥5.04 share price signals that it might be 40% undervalued
  • Zhongmin Energy's peers are currently trading at a premium of 1,490% on average

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Zhongmin Energy Co., Ltd. (SHSE:600163) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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 Zhongmin Energy

The Method

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

2025 2026 2027 2028 2029 2030 2031 2032 2033 2034
Levered FCF (CN¥, Millions) -CN¥72.0m -CN¥11.0m CN¥548.9m CN¥641.1m CN¥710.4m CN¥770.2m CN¥822.1m CN¥868.0m CN¥909.3m CN¥947.4m
Growth Rate Estimate Source Analyst x1 Analyst x1 Analyst x1 Analyst x1 Est @ 10.81% Est @ 8.42% Est @ 6.75% Est @ 5.58% Est @ 4.76% Est @ 4.19%
Present Value (CN¥, Millions) Discounted @ 6.9% -CN¥67.3 -CN¥9.6 CN¥449 CN¥490 CN¥508 CN¥515 CN¥514 CN¥507 CN¥497 CN¥484

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥3.9b

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 2.9%. We discount the terminal cash flows to today's value at a cost of equity of 6.9%.

Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = CN¥947m× (1 + 2.9%) ÷ (6.9%– 2.9%) = CN¥24b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥24b÷ ( 1 + 6.9%)10= CN¥12b

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¥16b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of CN¥5.0, the company appears quite undervalued at a 40% 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.

dcf
SHSE:600163 Discounted Cash Flow October 15th 2024

Important Assumptions

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 these result, have a go at the calculation yourself and play with the assumptions. 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 Zhongmin Energy 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 6.9%, which is based on a levered beta of 0.821. 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 Zhongmin Energy

Strength
  • Debt is not viewed as a risk.
  • Dividends are covered by earnings and cash flows.
Weakness
  • Earnings growth over the past year underperformed the Renewable Energy industry.
  • Dividend is low compared to the top 25% of dividend payers in the Renewable Energy 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
  • No apparent threats visible for 600163.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and 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. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. What is the reason for the share price sitting below the intrinsic value? For Zhongmin Energy, there are three pertinent items you should further research:

  1. Risks: As an example, we've found 1 warning sign for Zhongmin Energy that you need to consider before investing here.
  2. Future Earnings: How does 600163'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 Chinese stock every day, so if you want to find the intrinsic value of any other stock just search here.