A Look At The Fair Value Of Henan Lingrui Pharmaceutical Co., Ltd. (SHSE:600285)

Key Insights

• The projected fair value for Henan Lingrui Pharmaceutical is CN¥24.31 based on 2 Stage Free Cash Flow to Equity
• Henan Lingrui Pharmaceutical's CN¥25.12 share price indicates it is trading at similar levels as its fair value estimate
• Industry average of 128% suggests Henan Lingrui Pharmaceutical's peers are currently trading at a higher premium to fair value

How far off is Henan Lingrui Pharmaceutical Co., Ltd. (SHSE:600285) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Henan Lingrui Pharmaceutical

Is Henan Lingrui Pharmaceutical Fairly Valued?

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. 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.

Generally we assume that a dollar today is more valuable 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

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (CN¥, Millions)	CN¥705.5m	CN¥692.1m	CN¥689.0m	CN¥692.7m	CN¥701.4m	CN¥713.7m	CN¥728.6m	CN¥745.7m	CN¥764.3m	CN¥784.4m
Growth Rate Estimate Source	Est @ -3.95%	Est @ -1.90%	Est @ -0.46%	Est @ 0.55%	Est @ 1.26%	Est @ 1.75%	Est @ 2.09%	Est @ 2.34%	Est @ 2.51%	Est @ 2.62%
Present Value (CN¥, Millions) Discounted @ 7.4%	CN¥657	CN¥600	CN¥556	CN¥521	CN¥491	CN¥465	CN¥442	CN¥421	CN¥402	CN¥384

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥4.9b

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 (2.9%) 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 7.4%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = CN¥784m× (1 + 2.9%) ÷ (7.4%– 2.9%) = CN¥18b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥18b÷ ( 1 + 7.4%)¹⁰= CN¥8.8b

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¥14b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of CN¥25.1, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Henan Lingrui Pharmaceutical 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 7.4%, which is based on a levered beta of 0.800. 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.

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. The DCF model is not a perfect stock valuation tool. 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. 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 Henan Lingrui Pharmaceutical, we've compiled three fundamental aspects you should consider:

1. Risks: Be aware that Henan Lingrui Pharmaceutical is showing 1 warning sign in our investment analysis , you should know about...
2. Future Earnings: How does 600285'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 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!

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

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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com