China Literature Limited (HKG:772) shares may fall 49% below intrinsic value estimate

key insight

• The estimated fair value of China Literature is CN¥80.2 based on two-step free cash flow into the stock.
• Current stock price CN¥40.9 shows Chinese literature is 49% undervalued
• Analyst target price for 772 is 45.82 CN yen, 43% below fair value estimate

Today we perform one method of estimating the intrinsic value of China Literature Limited (HKG:772) by taking the company’s projected future cash flows and discounting them to today’s value. The discounted cash flow (DCF) model is the tool we apply to do this. Don’t let the jargon fool you. The math behind it is actually pretty simple.

Note that there are many methods of evaluating a company and, like DCF, each method has its strengths and weaknesses in certain scenarios. If you want to learn more about discounted cash flow, you can read more about the rationale behind this calculation in our Simply Wall St analytical model.

See the latest analysis of Chinese literature

Calculation step by step

We use a two stage growth model. This simply means taking into account his two phases of the company’s growth. In the early stage, the company may have a high growth rate, and it is usually assumed that there is a steady growth rate in the second stage. The first step is to estimate the cash flow to the business over the next 10 years. We use analyst estimates when available, but if these are not available, we extrapolate previous free cash flow (FCF) from previous estimates or reported values. Over this period, we expect companies with shrinking free cash flow to contract at a slower rate, and those with growing free cash flow to see slower growth. This is to reflect that growth tends to slow in the early years rather than in later years.

In general, we assume that a dollar today is worth more than a dollar in the future, so we need to discount the sum of these future cash flows to get an estimate of present value.

10-Year Free Cash Flow (FCF) Estimate

(“Est” = FCF growth rate estimated by Simply Wall St)
10-Year Present Value of Cash Flows (PVCF) = CNY 24 billion

The second stage, also called terminal value, is the cash flow of the business after the first stage. A very conservative growth rate is used that cannot exceed the country’s GDP growth rate for a number of reasons. In this case, we used the 5-year average of 10-year government bond yields (1.6%) to estimate future growth rates. Similar to the 10-year “growth” period, we discount future cash flows to their present value using a 7.3% cost of equity.

Terminal value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = CN¥53b× (1 + 1.6%) ÷ (7.3%– 1.6%) = CN¥94b

Present Value of Terminal Value (PVTV)= television / (1 + r)^Ten= CN¥94b÷ ( 1 + 7.3%)^Ten= CNY 46 billion

The total value, or equity value, is the sum of the present value of the future cash flows, in this case 700 CN yen. Divide this by the total number of outstanding shares to get the intrinsic value per share. Compared to the current stock price of HK$40.9, the company appears to be significantly undervalued, with his 49% discount to the current stock price. Assumptions can have a large impact on valuations in any calculation, so it’s best to consider this a rough estimate and not accurate to the last cent.

Assumption

The most important input to discounted cash flows is the discount rate and, of course, the actual cash flows. You do not have to consent to these inputs. I encourage you to redo the calculations yourself and play with them. The DCF also does not give a complete picture of a company’s potential performance, as it does not take into account the cyclicality of the industry or the company’s future capital requirements. Given that we look at Chinese literature as potential shareholders, the cost of capital is used as the discount rate rather than the cost of capital (or weighted average cost of capital, WACC) that accounts for the debt. For this calculation, we used 7.3% based on a leverage beta of 0.817. Beta is a measure of a stock’s volatility relative to the market as a whole. Our betas are derived from industry average betas of globally comparable companies and are capped between 0.8 and 2.0. This is a reasonable range for a stable business.

SWOT Analysis of Chinese Literature

Future plans:

Importantly, the DCF calculation is just one of many factors by which a company should be evaluated. A DCF model cannot give foolproof estimates. Instead, the DCF model’s best use is to test certain assumptions and theories to see if they lead to a company being undervalued or overvalued. If companies grow at different rates, or if their cost of capital or risk-free rates change abruptly, their outputs can look very different. Why is the intrinsic value higher than the current stock price? For Chinese literature, we’ve compiled three more items to consider.

1. risk: Every company has them and we found 1 Warning Signs in Chinese Literature you should know about
2. future earnings: How does 772’s growth rate compare to its peers and the wider market? Manipulate our free analyst growth forecast charts to dig deeper into analyst consensus numbers for the next few years.
3. Other solid businesses: Low debt, high return on equity and a strong past performance are the cornerstones of a strong business. Explore interactive stock listings with solid business fundamentals to see if there are other companies you haven’t considered!

PS. Simply Wall St updates his DCF calculations for all Hong Kong stocks daily, so if you want to know the intrinsic value of other stocks, search here.

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This article by Simply Wall St is general in nature. We provide comments based on historical data and analyst projections using only unbiased methodologies and our articles are not intended as financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. We aim to deliver long-term focused analysis based on fundamental data. Please note that our analysis may not take into account the latest price-sensitive company announcements or qualitative materials. Is not …