Is There An Opportunity With NetEase, Inc.'s (NASDAQ:NTES) 30% Undervaluation?

Simply Wall St.03-18

Key Insights The projected fair value for NetEase is US$153 based on 2 Stage Free Cash Flow to Equity NetEase's US$107 share price signals that it might be 30% undervalued Analyst price target ...

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NetEase's US$107 share price signals that it might be 30% undervalued. Analyst price target for NTES is CN136 which is 11% below our fair value estimate. Today we'll do a simple run through of a valuation method used to estimate the attractiveness of NetEase, Inc.  as an investment opportunity by projecting its future cash flows and then discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow  model. Believe it or not, it's not too difficult to follow, as you'll see from our example!We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. 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(NASDAQ:NTES) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example! \n We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. 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. \n View our latest analysis for NetEase \n Is NetEase Fairly Valued? \n We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To start off with, we need to estimate 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. \n Generally we assume that a dollar today is more valuable than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at a present value estimate: \n 10-year free cash flow (FCF) forecast \n\n\n\n\n2024\n2025\n2026\n2027\n2028\n2029\n2030\n2031\n2032\n2033\n\n\n Levered FCF (CN¥, Millions) \nCN¥35.5b\nCN¥39.6b\nCN¥41.9b\nCN¥43.7b\nCN¥45.3b\nCN¥46.8b\nCN¥48.1b\nCN¥49.5b\nCN¥50.8b\nCN¥52.1b\n\n\nGrowth Rate Estimate Source\nAnalyst x9\nAnalyst x10\nAnalyst x7\nEst @ 4.29%\nEst @ 3.69%\nEst @ 3.27%\nEst @ 2.98%\nEst @ 2.77%\nEst @ 2.63%\nEst @ 2.53%\n\n\n Present Value (CN¥, Millions) Discounted @ 8.3% \nCN¥32.8k\nCN¥33.7k\nCN¥32.9k\nCN¥31.7k\nCN¥30.3k\nCN¥28.9k\nCN¥27.5k\nCN¥26.1k\nCN¥24.7k\nCN¥23.4k\n\n\n\n(\"Est\" = FCF growth rate estimated by Simply Wall St)Present Value of 10-year Cash Flow (PVCF) = CN¥292b\n The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 2.3%. We discount the terminal cash flows to today's value at a cost of equity of 8.3%. \nTerminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = CN¥52b× (1 + 2.3%) ÷ (8.3%– 2.3%) = CN¥880b\nPresent Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥880b÷ ( 1 + 8.3%)10= CN¥395b\n The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is CN¥687b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$107, the company appears a touch undervalued at a 30% 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. \n\n\n\n  NasdaqGS:NTES Discounted Cash Flow March 18th 2024\n \n\n Important Assumptions \n Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 8.3%, which is based on a levered beta of 1.075. 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. \nSWOT Analysis for NetEase\n\n\nStrength\n\nEarnings growth over the past year exceeded the industry.\n\n\nDebt is not viewed as a risk.\n\n\nDividends are covered by earnings and cash flows.\n\n\nDividend information for NTES.\n\n\n\nWeakness\n\nDividend is low compared to the top 25% of dividend payers in the Entertainment market.\n\n\n\nOpportunity\n\nAnnual revenue is forecast to grow faster than the American market.\n\n\nGood value based on P/E ratio and estimated fair value.\n\n\n\nThreat\n\n Annual earnings are forecast to grow slower than the American market.\n\n\nWhat else are analysts forecasting for NTES?\n\n\n\n Next Steps: \n 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. 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. What is the reason for the share price sitting below the intrinsic value? For NetEase, we've compiled three important items you should assess: \n\n Risks: You should be aware of the 1 warning sign for NetEase we've uncovered before considering an investment in the company. \nFuture 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.\n 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! \n\n 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.\nHave 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. 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