Want to participate in a short research study? Help shape the future of investing tools and you could win a $250 gift card!
Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of Hengan International Group Company Limited (HKG:1044) as an investment opportunity by projecting its future cash flows and then discounting them to today’s value. I will be 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. Please also note that this article was written in February 2019 so be sure check out the updated calculation by following the link below.
View our latest analysis for Hengan International Group
The calculation
I’m 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 perpetual stable growth rate. To begin with we have to get estimates of 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
| 2019 | 2020 | 2021 | 2022 | 2023 | |
| Levered FCF (CN¥, Millions) | CN¥3.71k | CN¥3.79k | CN¥3.21k | CN¥3.37k | CN¥3.47k |
| Source | Analyst x11 | Analyst x10 | Analyst x1 | Analyst x1 | Analyst x1 |
| Present Value Discounted @ 8.4% | CN¥3.43k | CN¥3.23k | CN¥2.52k | CN¥2.44k | CN¥2.32k |
Present Value of 5-year Cash Flow (PVCF)= CN¥14b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after the five years. 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%). 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) = FCF2023 × (1 + g) ÷ (r – g) = CN¥3.5b × (1 + 2%) ÷ (8.4% – 2%) = CN¥55b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = CN¥55b ÷ ( 1 + 8.4%)5 = CN¥37b
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is CN¥51b. In the final step we 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) or ADR then we use the equivalent number. This results in an intrinsic value of HK$49.81. Relative to the current share price of HK$62.45, the stock is fair value, maybe slightly overvalued at the time of writing.
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 my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at Hengan International Group 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.
Next Steps:
Although the valuation of a company is important, it 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 1044, I’ve compiled three key aspects you should further examine:
- Financial Health: Does 1044 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 1044’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 1044? 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 editorial-team@simplywallst.com.