U.S. Markets open in 9 hrs 29 mins

Is There An Opportunity With Guangshen Railway Company Limited’s (HKG:525) 40.08% Undervaluation?

In this article I am going to calculate the intrinsic value of Guangshen Railway Company Limited (HKG:525) by taking the expected future cash flows and discounting them to their present value. This is done using the discounted cash flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. Please also note that this article was written in November 2018 so be sure check out the updated calculation by following the link below.

Check out our latest analysis for Guangshen Railway

Crunching the numbers

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second ‘steady growth’ period. To start off with we need to estimate the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount the sum of these cash flows to arrive at a present value estimate.

5-year cash flow estimate

2019 2020 2021 2022 2023
Levered FCF (CN¥, Millions) CN¥1.42k CN¥1.86k CN¥1.96k CN¥2.07k CN¥2.18k
Source Analyst x1 Analyst x1 Est @ 5.41% Est @ 5.41% Est @ 5.41%
Present Value Discounted @ 8.44% CN¥1.31k CN¥1.58k CN¥1.54k CN¥1.50k CN¥1.45k

Present Value of 5-year Cash Flow (PVCF)= CN¥7.4b

After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (2.2%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 8.4%.

Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = CN¥2.2b × (1 + 2.2%) ÷ (8.4% – 2.2%) = CN¥36b

Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = CN¥36b ÷ ( 1 + 8.4%)5 = CN¥24b

The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is CN¥31b. The last step is to then divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) then we use the equivalent number. This results in an intrinsic value in the company’s reported currency of CN¥4.4. However, 525’s primary listing is in China, and 1 share of 525 in CNY represents 1.125 ( CNY/ HKD) share of NYSE:GSH, so the intrinsic value per share in HKD is HK$4.96. Relative to the current share price of HK$2.97, the stock is quite good value at a 40% discount to what it is available for right now.

SEHK:525 Intrinsic Value Export November 15th 18

The assumptions

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 my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at Guangshen Railway as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 8.4%, which is based on a levered beta of 0.800. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

Next Steps:

Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For 525, I’ve compiled three pertinent aspects you should further research:

  1. Financial Health: Does 525 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 525’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: Are there other high quality stocks you could be holding instead of 525? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. Simply Wall St does a DCF calculation for every HK stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.