Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of China Resources Medical Holdings Company Limited (HKG:1515) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. This is done using the discounted cash flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. If you are reading this and its not October 2018 then I highly recommend you check out the latest calculation for China Resources Medical Holdings by following the link below.
Crunching the numbers
I use what is known as a 2-stage model, which simply means we have two different periods of varying growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a more stable growth phase. To start off with we need to estimate the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount the sum of these cash flows to arrive at a present value estimate.
5-year cash flow forecast
|Levered FCF (CN¥, Millions)||CN¥475.50||CN¥596.00||CN¥693.75||CN¥807.54||CN¥936.74|
|Source||Analyst x2||Analyst x2||Est @ 16.4%||Est @ 16.4%||Est @ 16%, capped from 16.4%|
|Present Value Discounted @ 8.44%||CN¥438.49||CN¥506.83||CN¥544.04||CN¥583.98||CN¥624.69|
Present Value of 5-year Cash Flow (PVCF)= CN¥2.7b
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 the GDP. In this case I have used the 10-year government bond rate (2.2%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 8.4%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = CN¥937m × (1 + 2.2%) ÷ (8.4% – 2.2%) = CN¥15.3b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = CN¥15.3b ÷ ( 1 + 8.4%)5 = CN¥10.2b
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is CN¥12.9b. The last step is to then divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) then we use the equivalent number. This results in an intrinsic value in the company’s reported currency of CN¥9.97. However, 1515’s primary listing is in China, and 1 share of 1515 in CNY represents 1.132 ( CNY/ HKD) share of SEHK:1515, so the intrinsic value per share in HKD is HK$11.29. Relative to the current share price of HK$6.63, the stock is quite undervalued at a 41% discount to what it is available for right now.
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 my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at China Resources Medical Holdings as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 8.4%, which is based on a levered beta of 0.800. This is derived from the Bottom-Up Beta method based on 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. What is the reason for the share price to differ from the intrinsic value? For 1515, I’ve put together three pertinent aspects you should look at:
- Financial Health: Does 1515 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.
- Future Earnings: How does 1515’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.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of 1515? 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 does a DCF calculation for every HK stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.