Calculation of the fair value of Li Ning Company Limited (HKG: 2331)


How far is Li Ning Company Limited (HKG: 2331) from its intrinsic value? Using the most recent financial data, we’ll examine whether the stock’s price is fair by projecting its future cash flows and then discounting them to present value. To this end, we will take advantage of 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.

There are many ways that businesses can be assessed, so we would like to point out that a DCF is not perfect for all situations. If you still have burning questions about this type of valuation, take a look at Simply Wall St.

Check out our latest analysis for Li Ning

What is the estimated valuation?

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 a lower growth stage. First, 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.

Generally, we assume that a dollar today is worth more 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
Leverage FCF (CN ¥, Million) CN ¥ 4.70b CN ¥ 5.97b CN ¥ 7.98b CN ¥ 9.35b CN ¥ 10.3b CN ¥ 11.2b CN ¥ 11.8b CN ¥ 12.4b CN ¥ 12.8b CN ¥ 13.2b
Source of estimated growth rate Analyst x10 Analyst x10 Analyst x3 Analyst x2 Est @ 10.65% Is at 7.9% Est @ 5.98% East @ 4.63% East @ 3.68% East @ 3.02%
Present value (CN ¥, Million) discounted at 6.7% CN ¥ 4.4k CN ¥ 5.2k CN ¥ 6.6k CN ¥ 7.2k CN ¥ 7.5k CN ¥ 7.6k CN ¥ 7.5k CN ¥ 7.4k CN ¥ 7.2k CN ¥ 6.9k

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = CN ¥ 67b

The second stage is also known as terminal value, this is the cash flow of the business after the first stage. 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 6.7%.

Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = CN Â¥ 13b × (1 + 1.5%) ÷ (6.7% – 1.5%) = CN Â¥ 258b

Present value of terminal value (PVTV)= TV / (1 + r)ten= CN ¥ 258b ÷ (1 + 6.7%)ten= CN ¥ 135b

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 Â¥ 202b. The last step is then to divide the equity value by the number of shares outstanding. Compared to the current share price of HK $ 86.1, the company appears to be roughly at fair value with a discount of 8.9% from the current share price. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.

SEHK: 2331 Discounted Cash Flows November 29, 2021

The hypotheses

The above calculation is very dependent on two assumptions. One is the discount rate and the other is the 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 Li Ning as a potential shareholder, 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 6.7%, which is based on a leveraged beta of 1.047. 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.

To move on :

Valuation is only one side of the coin in terms of building your investment thesis, and it’s just one of the many factors you need to evaluate for a business. It is not possible to achieve a rock-solid valuation with a DCF model. 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, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. For Li Ning, we have put together three essential aspects that you should consider:

  1. Risks: Every company has them, and we have spotted 3 warning signs for Li Ning you should know.
  2. Management: Have insiders increased their stocks to take advantage of market sentiment regarding the outlook for 2331? Check out our management and board analysis with information on CEO compensation and governance factors.
  3. Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what you might be missing!

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.

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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