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Is There An Opportunity With NetEase, Inc.'s (NASDAQ:NTES) 44% Undervaluation?

Key Insights

  • NetEase's estimated fair value is US$160 based on 2 Stage Free Cash Flow to Equity

  • NetEase is estimated to be 44% undervalued based on current share price of US$90.42

  • The CN¥134 analyst price target for NTES is 16% less than our estimate of fair value

Does the April share price for NetEase, Inc. (NASDAQ:NTES) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. It may sound complicated, but actually it is quite simple!

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.

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See our latest analysis for NetEase

The Calculation

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 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

2024

2025

2026

2027

2028

2029

2030

2031

2032

2033

Levered FCF (CN¥, Millions)

CN¥35.6b

CN¥37.2b

CN¥41.9b

CN¥44.7b

CN¥47.2b

CN¥49.3b

CN¥51.2b

CN¥52.9b

CN¥54.5b

CN¥56.1b

Growth Rate Estimate Source

Analyst x9

Analyst x9

Analyst x7

Est @ 6.83%

Est @ 5.47%

Est @ 4.52%

Est @ 3.85%

Est @ 3.38%

Est @ 3.05%

Est @ 2.82%

Present Value (CN¥, Millions) Discounted @ 8.4%

CN¥32.8k

CN¥31.7k

CN¥32.9k

CN¥32.4k

CN¥31.6k

CN¥30.5k

CN¥29.2k

CN¥27.9k

CN¥26.5k

CN¥25.1k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥301b

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 (2.3%) 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 8.4%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = CN¥56b× (1 + 2.3%) ÷ (8.4%– 2.3%) = CN¥946b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥946b÷ ( 1 + 8.4%)10= CN¥424b

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¥725b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of US$90.4, the company appears quite undervalued at a 44% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf
dcf

The Assumptions

We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 8.4%, which is based on a levered beta of 1.077. 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

  • 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 and estimated fair value.

Threat

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

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and 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. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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 put together three additional aspects you should look at:

  1. Risks: Every company has them, and we've spotted 1 warning sign for NetEase you should know about.

  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. Simply Wall St updates its DCF calculation for every American stock every day, so if you want to find the intrinsic value of any other stock 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.