An Intrinsic Calculation For GemPharmatech Co., Ltd. (SHSE:688046) Suggests It's 44% Undervalued

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, GemPharmatech fair value estimate is CN¥26.00
• Current share price of CN¥14.65 suggests GemPharmatech is potentially 44% undervalued
• Analyst price target for 688046 is CN¥16.75 which is 36% below our fair value estimate

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of GemPharmatech Co., Ltd. (SHSE:688046) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

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.

Check out our latest analysis for GemPharmatech

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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, 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¥12.0m	CN¥70.0m	CN¥132.6m	CN¥216.6m	CN¥314.6m	CN¥416.8m	CN¥515.1m	CN¥604.5m	CN¥683.0m	CN¥750.8m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ 89.38%	Est @ 63.40%	Est @ 45.22%	Est @ 32.50%	Est @ 23.59%	Est @ 17.35%	Est @ 12.99%	Est @ 9.93%
Present Value (CN¥, Millions) Discounted @ 7.3%	-CN¥11.2	CN¥60.8	CN¥107	CN¥163	CN¥221	CN¥273	CN¥314	CN¥343	CN¥362	CN¥370

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥2.2b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 (2.8%) 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 7.3%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = CN¥751m× (1 + 2.8%) ÷ (7.3%– 2.8%) = CN¥17b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥17b÷ ( 1 + 7.3%)¹⁰= CN¥8.4b

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¥11b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of CN¥14.7, the company appears quite undervalued at a 44% discount to where the stock price trades currently. 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.

The 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 GemPharmatech 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 7.3%, which is based on a levered beta of 0.908. 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 GemPharmatech

Looking Ahead:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching 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. Why is the intrinsic value higher than the current share price? For GemPharmatech, there are three additional items you should look at:

1. Risks: Be aware that GemPharmatech is showing 1 warning sign in our investment analysis , you should know about...
2. Future Earnings: How does 688046'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the SHSE every day. If you want to find the calculation for other stocks 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.