Is There An Opportunity With Shandong Weigao Group Medical Polymer Company Limited's (HKG:1066) 42% Undervaluation?

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Shandong Weigao Group Medical Polymer Company Limited (HKG:1066) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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. 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 Shandong Weigao Group Medical Polymer

The method

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 begin with, we have to get estimates of 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.

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

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (CN¥, Millions)	CN¥2.18b	CN¥2.44b	CN¥2.59b	CN¥2.72b	CN¥2.82b	CN¥2.91b	CN¥2.99b	CN¥3.06b	CN¥3.12b	CN¥3.18b
Growth Rate Estimate Source	Analyst x2	Analyst x2	Est @ 6.4%	Est @ 4.93%	Est @ 3.89%	Est @ 3.17%	Est @ 2.66%	Est @ 2.31%	Est @ 2.06%	Est @ 1.89%
Present Value (CN¥, Millions) Discounted @ 6.1%	CN¥2.1k	CN¥2.2k	CN¥2.2k	CN¥2.1k	CN¥2.1k	CN¥2.0k	CN¥2.0k	CN¥1.9k	CN¥1.8k	CN¥1.8k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥20b

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 1.5%. We discount the terminal cash flows to today's value at a cost of equity of 6.1%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = CN¥3.2b× (1 + 1.5%) ÷ (6.1%– 1.5%) = CN¥70b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥70b÷ ( 1 + 6.1%)¹⁰= CN¥38b

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¥59b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of HK$9.2, the company appears quite good value at a 42% 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.

Important 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 Shandong Weigao Group Medical Polymer 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 6.1%, which is based on a levered beta of 0.934. 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.

Next Steps:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for 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?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Shandong Weigao Group Medical Polymer, we've compiled three important factors you should further research:

1. Risks: For example, we've discovered 1 warning sign for Shandong Weigao Group Medical Polymer that you should be aware of before investing here.
2. Future Earnings: How does 1066'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 SEHK 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.