An Intrinsic Calculation For Hua Hong Semiconductor Limited (HKG:1347) Suggests It's 45% Undervalued

Simply Wall St · 10/17 22:33

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, Hua Hong Semiconductor fair value estimate is HK$38.24
  • Current share price of HK$21.20 suggests Hua Hong Semiconductor is potentially 45% undervalued
  • Our fair value estimate is 77% higher than Hua Hong Semiconductor's analyst price target of US$21.57

How far off is Hua Hong Semiconductor Limited (HKG:1347) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by projecting its future cash flows and then discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

View our latest analysis for Hua Hong Semiconductor

Is Hua Hong Semiconductor Fairly Valued?

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 begin with, we have to get estimates of 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, 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 ($, Millions) -US$910.4m -US$744.3m -US$437.6m US$396.0m US$587.0m US$789.1m US$984.7m US$1.16b US$1.32b US$1.45b
Growth Rate Estimate Source Analyst x9 Analyst x9 Analyst x2 Analyst x1 Est @ 48.23% Est @ 34.44% Est @ 24.78% Est @ 18.02% Est @ 13.29% Est @ 9.98%
Present Value ($, Millions) Discounted @ 10% -US$826 -US$613 -US$327 US$268 US$361 US$440 US$498 US$533 US$548 US$547

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$1.4b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (2.3%) 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 10%.

Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = US$1.4b× (1 + 2.3%) ÷ (10%– 2.3%) = US$19b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$19b÷ ( 1 + 10%)10= US$7.0b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$8.4b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of HK$21.2, the company appears quite good value at a 45% 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.

dcf
SEHK:1347 Discounted Cash Flow October 17th 2024

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Hua Hong Semiconductor 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 10%, which is based on a levered beta of 1.601. 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 Hua Hong Semiconductor

Strength
  • Debt is not viewed as a risk.
Weakness
  • Earnings declined over the past year.
  • Dividend is low compared to the top 25% of dividend payers in the Semiconductor market.
Opportunity
  • Annual earnings are forecast to grow faster than the Hong Kong market.
  • Trading below our estimate of fair value by more than 20%.
Threat
  • Revenue is forecast to grow slower than 20% per year.

Looking Ahead:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Hua Hong Semiconductor, there are three fundamental aspects you should assess:

  1. Risks: You should be aware of the 2 warning signs for Hua Hong Semiconductor we've uncovered before considering an investment in the company.
  2. Future Earnings: How does 1347'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.