Xiaomi Corporation (HKG: 1810) shares could be 31% higher than their intrinsic value estimate
Today we’re going to go over one way to estimate the intrinsic value of Xiaomi Corporation (HKG: 1810) by taking expected future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Before you think you won’t be able to figure it out, read on! It’s actually a lot less complex than you might imagine.
We draw your attention to the fact that there are many ways to assess a business and, like DCF, each technique has advantages and disadvantages in certain scenarios. If you still have burning questions about this type of valuation, take a look at the Simply Wall St.
See our latest review for Xiaomi
The method
We use the 2-step growth model, which simply means that we take into account two stages of business growth. In the initial period, the business can have a higher growth rate, and the second stage is usually assumed to have a stable growth rate. 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.
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 arrive at an estimate of the present value:
10-year Free Cash Flow (FCF) estimate
2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | |
Leverage FCF (CN ¥, Million) | CN ¥ 23.7b | CN ¥ 25.8b | CN ¥ 26.3b | CN ¥ 25.0b | CN ¥ 24.3b | CN ¥ 23.9b | CN ¥ 23.7b | CN ¥ 23.7b | CN ¥ 23.8b | CN ¥ 24.0b |
Source of estimated growth rate | Analyst x11 | Analyst x8 | Analyst x3 | Analyst x2 | East @ -2.91% | Is @ -1.59% | East @ -0.67% | East @ -0.03% | East @ 0.43% | East @ 0.74% |
Present value (CN ¥, million) discounted at 7.5% | CN ¥ 22.0k | CN ¥ 22.4k | CN ¥ 21.2k | CN ¥ 18.7k | CN ¥ 16.9k | CN ¥ 15.5k | CN ¥ 14.3k | CN ¥ 13.3k | CN ¥ 12.4k | CN ¥ 11.7k |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = CN ¥ 168b
It is now a matter of calculating the Terminal Value, which takes into account all future cash flows after this ten-year period. The Gordon growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.5%. We discount the terminal cash flows to their present value at a cost of equity of 7.5%.
Terminal value (TV)= FCF_{2031} × (1 + g) ÷ (r – g) = CN ¥ 24b × (1 + 1.5%) ÷ (7.5% – 1.5%) = CN ¥ 406b
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= CN ¥ 406b ÷ (1 + 7.5%)^{ten}= CN ¥ 197b
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 ¥ 365b. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of HK $ 23.0, the company looks potentially overvalued at the time of writing. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.
The hypotheses
Now the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. Part of investing is coming up with your own assessment of a company’s future performance, so try the math yourself and check your own 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 complete picture of a company’s potential performance. Since we view Xiaomi 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 have used 7.5%, which is based on a leveraged beta of 1.112. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
To move on :
While important, calculating DCF is just one of the many factors you need to assess for a business. It is not possible to achieve a rock-solid valuation with a DCF model. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. Why is intrinsic value lower than the current share price? For Xiaomi, we have compiled three fundamental things that you should take a closer look at:
- Risks: Concrete example, we have spotted 3 warning signs for Xiaomi you must be aware.
- Future benefits: How does the growth rate of 1810 compare with that of its peers and the market at large? Dig deeper into the analyst consensus number for years to come by interacting with our free analyst growth expectations chart.
- 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. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. 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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