Is Shanghai Electric Group Company Limited (HKG:2727) Expensive For A Reason? A Look At The Intrinsic Value

Simply Wall St.

Sun, Oct 7, 2018, 7:18 PM

How far off is Shanghai Electric Group Company Limited (HKG:2727) from its intrinsic value? Using the most recent financial data, I am going to take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to today’s value. This is done using the discounted cash flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. If you are reading this and its not October 2018 then I highly recommend you check out the latest calculation for Shanghai Electric Group by following the link below.

View our latest analysis for Shanghai Electric Group

The model

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 five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount this to its value today and sum up the total to get the present value of these cash flows.

5-year cash flow estimate

	2019	2020	2021	2022	2023
Levered FCF (CN¥, Millions)	CN¥-23.05k	CN¥4.29k	CN¥4.40k	CN¥4.53k	CN¥4.65k
Source	Analyst x1	Analyst x1	Est @ 2.75%	Est @ 2.75%	Est @ 2.75%
Present Value Discounted @ 10.14%	CN¥-20.93k	CN¥3.53k	CN¥3.30k	CN¥3.08k	CN¥2.87k

Present Value of 5-year Cash Flow (PVCF)= -CN¥8.2b

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 an annual growth rate equal to the 10-year government bond rate of 2.2%. We discount this to today’s value at a cost of equity of 10.1%.

Terminal Value (TV) = FCF₂₀₂₂ × (1 + g) ÷ (r – g) = CN¥4.7b × (1 + 2.2%) ÷ (10.1% – 2.2%) = CN¥59.9b

Present Value of Terminal Value (PVTV) = TV / (1 + r)⁵ = CN¥59.9b ÷ ( 1 + 10.1%)⁵ = CN¥37.0b

The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is CN¥28.8b. In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number. This results in an intrinsic value in the company’s reported currency of CN¥1.96. However, 2727’s primary listing is in China, and 1 share of 2727 in CNY represents 1.141 ( CNY/ HKD) share of SEHK:2727, so the intrinsic value per share in HKD is HK$2.23. Relative to the current share price of HK$2.74, the stock is fair value, maybe slightly overvalued at the time of writing.

SEHK:2727 Intrinsic Value Export October 8th 18

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 my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at Shanghai Electric Group as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 10.1%, which is based on a levered beta of 1.018. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

Next Steps:

Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For 2727, I’ve compiled three key aspects you should look at:

Financial Health: Does 2727 have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
Future Earnings: How does 2727’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.
Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of 2727? 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 does a DCF calculation for every HK stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.

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