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Calculating The Intrinsic Value Of NetEase, Inc. (NASDAQ:NTES)

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, NetEase fair value estimate is US$82.79

  • With US$83.77 share price, NetEase appears to be trading close to its estimated fair value

  • Our fair value estimate is 23% lower than NetEase's analyst price target of CN¥107

Today we will run through one way of estimating 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. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

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See our latest analysis for NetEase

Crunching The Numbers

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. To begin with, we have to get estimates of the next ten years of cash flows. 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.

A DCF is all about the idea that a dollar in the future is less valuable 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) estimate

2023

2024

2025

2026

2027

2028

2029

2030

2031

2032

Levered FCF (CN¥, Millions)

CN¥22.3b

CN¥27.5b

CN¥28.2b

CN¥28.9b

CN¥29.5b

CN¥30.2b

CN¥30.8b

CN¥31.5b

CN¥32.2b

CN¥32.9b

Growth Rate Estimate Source

Analyst x10

Analyst x10

Analyst x7

Est @ 2.33%

Est @ 2.26%

Est @ 2.22%

Est @ 2.18%

Est @ 2.16%

Est @ 2.15%

Est @ 2.14%

Present Value (CN¥, Millions) Discounted @ 9.5%

CN¥20.3k

CN¥22.9k

CN¥21.5k

CN¥20.1k

CN¥18.8k

CN¥17.5k

CN¥16.4k

CN¥15.3k

CN¥14.3k

CN¥13.3k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥180b

The second stage is also known as Terminal Value, this is the business's cash flow 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 have used the 5-year average of the 10-year government bond yield (2.1%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 9.5%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = CN¥33b× (1 + 2.1%) ÷ (9.5%– 2.1%) = CN¥457b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥457b÷ ( 1 + 9.5%)10= CN¥185b

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¥365b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$83.8, the company appears around fair value at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

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. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 9.5%, which is based on a levered beta of 1.027. 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.

SWOT Analysis for NetEase

Strength

  • Earnings growth over the past year exceeded the industry.

  • Debt is not viewed as a risk.

  • Dividends are covered by earnings and cash flows.

Weakness

  • Earnings growth over the past year is below its 5-year average.

  • Dividend is low compared to the top 25% of dividend payers in the Entertainment market.

Opportunity

  • Annual revenue is forecast to grow faster than the American market.

  • Good value based on P/E ratio compared to estimated Fair P/E ratio.

Threat

  • Annual earnings are forecast to grow slower than the American market.

Moving On:

Although the valuation of a company is important, it 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. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For NetEase, we've put together three further aspects you should further examine:

  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 Solid Businesses: 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 business fundamentals to see if there are other companies you may not have considered!

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.

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