Does the June price of Xinyi Solar Holdings Limited (HKG:968) share reflect what it is really worth? Today we are going to estimate the intrinsic value of the stock by estimating the future cash flows of the company and discounting them to their present value. One way to do this is to use the discounted cash flow (DCF) model. Patterns like these may seem beyond a layman’s comprehension, but they’re pretty easy to follow.

We generally believe that the value of a company is the present value of all the cash it will generate in the future. However, a DCF is just one of many evaluation metrics, and it is not without its flaws. For those who are passionate about stock analysis, the Simply Wall St analysis template here may interest you.

See our latest analysis for Xinyi Solar Holdings

The calculation

We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “sustained growth”. To start, we need to estimate the cash flows for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported 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 more in early years than in later years.

A DCF is based on the idea that a dollar in the future is worth less 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) Forecast

(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = HK$21 billion

The second stage is also known as the terminal value, it is the cash flow of the business after the first stage. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 1.5%. We discount terminal cash flows to present value at a cost of equity of 7.3%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = HK$8.0 billion × (1 + 1.5%) ÷ (7.3%–1.5%) = HK$140 billion Kong

Present value of terminal value (PVTV)= TV / (1 + r)^ten= HK$140 billion÷ (1+7.3%)^ten= HK$69 billion

The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is HK$90 billion. 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$12.7, the company appears slightly overvalued at the time of writing. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep that in mind.

The hypotheses

Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flows. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play around with them. 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 complete picture of a company’s potential performance. Since we consider Xinyi Solar Holdings 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 7.3%, which is based on a leveraged beta of 1.183. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

Let’s move on :

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won’t be the only piece of analysis you look at for a company. DCF models are not the be-all and end-all of investment valuation. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. If a company grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output may be very different. Why is intrinsic value lower than the current stock price? For Xinyi Solar Holdings, we have compiled three essential factors that you should evaluate:

1. Financial health: Does 968 have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors such as leverage and risk.
2. Future earnings: How does 968’s growth rate compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
3. Other strong companies: Low debt, high returns on equity and good past performance are essential to a strong business. Why not explore our interactive list of stocks with strong trading fundamentals to see if there are any other companies you may not have considered!

PS. Simply Wall St updates its DCF calculation for every Hong Kong stock daily, so if you want to find the intrinsic value of any other stock, just search here.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.