Today we will run through one way of estimating the intrinsic value of China Pharma Holdings, Inc. (NYSEMKT:CPHI) by taking the expected future cash flows and discounting them to their present value. I will use the Discounted Cash Flow (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward.
Remember though, that there are many ways to estimate a company’s value, and a DCF is just one method. 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.
What’s the estimated valuation?
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 start off with, we need to estimate the next ten years of cash flows. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company’s last 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, and so the sum of these future cash flows is then discounted to today’s value:
10-year free cash flow (FCF) estimate
|Levered FCF ($, Millions)||US$1.39m||US$1.30m||US$1.25m||US$1.22m||US$1.21m||US$1.20m||US$1.21m||US$1.22m||US$1.23m||US$1.25m|
|Growth Rate Estimate Source||Est @ -9.97%||Est @ -6.46%||Est @ -4%||Est @ -2.28%||Est @ -1.07%||Est @ -0.23%||Est @ 0.36%||Est @ 0.78%||Est @ 1.06%||Est @ 1.27%|
|Present Value ($, Millions) Discounted @ 7.6%||US$1.3||US$1.1||US$1.0||US$0.9||US$0.8||US$0.8||US$0.7||US$0.7||US$0.6||US$0.6|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$8.0m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 10-year government bond rate (1.7%) 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 7.6%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = US$1.2m× (1 + 1.7%) ÷ 7.6%– 1.7%) = US$22m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$22m÷ ( 1 + 7.6%)10= US$10m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$18m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$0.4, the company appears about fair value at a 2.5% 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.
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. 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 China Pharma Holdings 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 7.6%, which is based on a levered beta of 0.930. 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.
Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to “what assumptions need to be true for this stock to be under/overvalued?” If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For China Pharma Holdings, There are three relevant aspects you should look at:
- Financial Health: Does CPHI 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.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of CPHI? 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 updates its DCF calculation for every US stock every day, so if you want to find the intrinsic value of any other stock just search here.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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