An Intrinsic Calculation For Modern Dental Group Limited (HKG:3600) Suggests It's 47% Undervalued

In this article we are going to estimate the intrinsic value of Modern Dental Group Limited (HKG:3600) 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. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

See our latest analysis for Modern Dental Group

Step by step through 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

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (HK$, Millions)	HK$563.0m	HK$706.0m	HK$711.0m	HK$717.7m	HK$725.6m	HK$734.5m	HK$744.0m	HK$754.0m	HK$764.5m	HK$775.3m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ 0.71%	Est @ 0.94%	Est @ 1.1%	Est @ 1.22%	Est @ 1.3%	Est @ 1.35%	Est @ 1.39%	Est @ 1.42%
Present Value (HK$, Millions) Discounted @ 6.4%	HK$529	HK$623	HK$590	HK$559	HK$531	HK$505	HK$481	HK$458	HK$436	HK$416

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = HK$5.1b

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. 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 6.4%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = HK$775m× (1 + 1.5%) ÷ (6.4%– 1.5%) = HK$16b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= HK$16b÷ ( 1 + 6.4%)¹⁰= HK$8.5b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is HK$14b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of HK$7.5, the company appears quite undervalued at a 47% 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.

Important 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 Modern Dental Group 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 6.4%, which is based on a levered beta of 0.933. 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.

Looking Ahead:

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. 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 Modern Dental Group, there are three additional aspects you should consider:

1. Risks: Every company has them, and we've spotted 1 warning sign for Modern Dental Group you should know about.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for 3600'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. 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.
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