In this article, we will estimate the intrinsic value of Yidu Tech Inc. (HKG: 2158) by taking expected future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. There really isn’t much to do, although it might seem quite complex.

Remember, however, that there are many ways to estimate the value of a business, and a DCF is just one method. If you still have burning questions about this type of valuation, take a look at the Simply Wall St.

See our latest review for Yidu Tech

The model

We use what is called a two-step model, which simply means that we have two different periods of growth rate for the cash flow of the business. Usually the first stage is higher growth and the second stage is lower growth stage. In the first step, we need to estimate the cash flow of the business over the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated value. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent years.

A DCF is based on the idea that a dollar in the future is worth less than a dollar today, and therefore the sum of those future cash flows is then discounted to today’s value. :

10-year Free Cash Flow (FCF) estimate

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = CN ¥ 5.9b

After calculating the present value of future cash flows over the initial 10 year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first step. 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 used the 5-year average of the 10-year government bond yield (1.5%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to their present value, using a cost of equity of 5.9%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = CN ¥ 1.9b × (1 + 1.5%) ÷ (5.9% – 1.5%) = CN ¥ 43b

Present value of terminal value (PVTV)= TV / (1 + r)^ten= CN ¥ 43b ÷ (1 + 5.9%)^ten= CN ¥ 24b

The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total value of equity, which in this case is CN ¥ 30b. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of HK $ 31.6, the company appears to be roughly at fair value with a 19% discount to the current share price. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.

Important assumptions

We draw your attention to the fact that 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 results, try the calculation yourself and play with the assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a full picture of a company’s potential performance. Since we consider Yidu Tech 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 takes debt into account. In this calculation, we used 5.9%, which is based on a leveraged beta of 0.821. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our beta from the industry average beta from globally comparable companies, with a limit imposed between 0.8 and 2.0, which is a reasonable range for a stable business.

Next steps:

While a business valuation is important, it shouldn’t be the only metric you look at when researching a business. DCF models are not the alpha and omega of investment valuation. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. For Yidu Tech, we’ve compiled three more things you should dig into:

1. Risks: For example, we discovered 2 warning signs for Yidu Tech which you should know before investing here.
2. Future benefits: How does 2158’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth expectations chart.
3. Other strong companies: 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 trading fundamentals to see if there are other companies you might not have considered!

PS. The Simply Wall St app performs a daily discounted cash flow assessment for each SEHK share. If you want to find the calculation for other actions, just search here.

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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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