Calculating The Fair Value Of Wenzhou Kangning Hospital Co., Ltd. (HKG:2120)

How far off is Wenzhou Kangning Hospital Co., Ltd. (HKG:2120) 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. 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.

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. 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.

See our latest analysis for Wenzhou Kangning Hospital

The method

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. 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) forecast

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (CN¥, Millions)	CN¥33.6m	CN¥50.6m	CN¥68.9m	CN¥86.6m	CN¥102.5m	CN¥116.2m	CN¥127.5m	CN¥136.8m	CN¥144.4m	CN¥150.6m
Growth Rate Estimate Source	Est @ 72.01%	Est @ 50.85%	Est @ 36.04%	Est @ 25.67%	Est @ 18.41%	Est @ 13.33%	Est @ 9.78%	Est @ 7.29%	Est @ 5.55%	Est @ 4.33%
Present Value (CN¥, Millions) Discounted @ 6.3%	CN¥31.6	CN¥44.8	CN¥57.3	CN¥67.7	CN¥75.4	CN¥80.4	CN¥83.0	CN¥83.7	CN¥83.1	CN¥81.5

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥688m

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 (1.5%) 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 6.3%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = CN¥151m× (1 + 1.5%) ÷ (6.3%– 1.5%) = CN¥3.2b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥3.2b÷ ( 1 + 6.3%)¹⁰= CN¥1.7b

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¥2.4b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of HK$46.1, the company appears around fair value at the time of writing. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

Important assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Wenzhou Kangning Hospital 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 6.3%, which is based on a levered beta of 0.898. 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:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. 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. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Wenzhou Kangning Hospital, we've put together three essential factors you should further research:

1. Risks: Every company has them, and we've spotted 1 warning sign for Wenzhou Kangning Hospital you should know about.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for 2120's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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 Hong Kong 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. 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.
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