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Are Investors Undervaluing NetEase, Inc. (NASDAQ:NTES) By 48%?

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In this article we are going to estimate the intrinsic value of NetEase, Inc. (NASDAQ:NTES) by estimating the company's future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

View our latest analysis for NetEase

The calculation

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. In the first stage we need to estimate the cash flows to the business over the next ten years. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

2022

2023

2024

2025

2026

2027

2028

2029

2030

2031

Levered FCF (CN¥, Millions)

CN¥22.9b

CN¥24.3b

CN¥29.6b

CN¥33.1b

CN¥37.7b

CN¥41.0b

CN¥43.8b

CN¥46.1b

CN¥48.1b

CN¥49.8b

Growth Rate Estimate Source

Analyst x13

Analyst x12

Analyst x4

Analyst x3

Analyst x3

Est @ 8.83%

Est @ 6.77%

Est @ 5.33%

Est @ 4.32%

Est @ 3.61%

Present Value (CN¥, Millions) Discounted @ 7.0%

CN¥21.4k

CN¥21.2k

CN¥24.2k

CN¥25.3k

CN¥26.9k

CN¥27.4k

CN¥27.3k

CN¥26.9k

CN¥26.2k

CN¥25.4k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥252b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 7.0%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = CN¥50b× (1 + 2.0%) ÷ (7.0%– 2.0%) = CN¥1.0t

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥1.0t÷ ( 1 + 7.0%)10= CN¥518b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is CN¥770b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$97.2, the company appears quite good value at a 48% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

dcf
dcf

Important assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at NetEase 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 accounts for debt. In this calculation we've used 7.0%, which is based on a levered beta of 1.007. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

Next Steps:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For NetEase, we've compiled three further items you should consider:

  1. Financial Health: Does NTES 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.

  2. Future Earnings: How does NTES'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.

  3. Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NASDAQGS every day. If you want to find the calculation for other stocks just search here.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.