Stock Analysis

Hualan Biological Engineering Inc. (SZSE:002007) Shares Could Be 36% Below Their Intrinsic Value Estimate

SZSE:002007
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Key Insights

Today we will run through one way of estimating the intrinsic value of Hualan Biological Engineering Inc. (SZSE:002007) by taking the forecast future cash flows of the company and discounting them back to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for Hualan Biological Engineering

The Calculation

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, 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

2025 2026 2027 2028 2029 2030 2031 2032 2033 2034
Levered FCF (CN¥, Millions) CN¥2.48b CN¥2.32b CN¥3.10b CN¥2.93b CN¥2.84b CN¥2.81b CN¥2.82b CN¥2.84b CN¥2.88b CN¥2.94b
Growth Rate Estimate Source Analyst x1 Analyst x1 Analyst x1 Analyst x1 Est @ -2.81% Est @ -1.11% Est @ 0.07% Est @ 0.91% Est @ 1.49% Est @ 1.90%
Present Value (CN¥, Millions) Discounted @ 7.4% CN¥2.3k CN¥2.0k CN¥2.5k CN¥2.2k CN¥2.0k CN¥1.8k CN¥1.7k CN¥1.6k CN¥1.5k CN¥1.4k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥19b

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 (2.9%) 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¥2.9b× (1 + 2.9%) ÷ (7.4%– 2.9%) = CN¥66b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥66b÷ ( 1 + 7.4%)10= CN¥32b

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¥51b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of CN¥17.9, the company appears quite good value at a 36% 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
SZSE:002007 Discounted Cash Flow October 7th 2024

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 Hualan Biological Engineering 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 0.918. 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 Hualan Biological Engineering

Strength
  • Earnings growth over the past year exceeded the industry.
  • Debt is not viewed as a risk.
Weakness
  • Dividend is low compared to the top 25% of dividend payers in the Biotechs market.
Opportunity
  • Annual revenue is forecast to grow faster than the Chinese market.
  • Good value based on P/E ratio and estimated fair value.
Threat
  • Dividends are not covered by cash flow.
  • Annual earnings are forecast to grow slower than the Chinese market.

Moving On:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. 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. Can we work out why the company is trading at a discount to intrinsic value? For Hualan Biological Engineering, we've compiled three further elements you should look at:

  1. Risks: Be aware that Hualan Biological Engineering is showing 1 warning sign in our investment analysis , you should know about...
  2. Future Earnings: How does 002007'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 Chinese stock every day, so if you want to find the intrinsic value of any other stock just search here.

Valuation is complex, but we're here to simplify it.

Discover if Hualan Biological Engineering might be undervalued or overvalued with our detailed analysis, featuring fair value estimates, potential risks, dividends, insider trades, and its financial condition.

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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.