Are Investors Undervaluing 3SBio Inc. (HKG:1530) By 42%?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, 3SBio fair value estimate is HK$33.12
• 3SBio is estimated to be 42% undervalued based on current share price of HK$19.18
• Our fair value estimate is 110% higher than 3SBio's analyst price target of CN¥15.78

In this article we are going to estimate the intrinsic value of 3SBio Inc. (HKG:1530) by taking the expected future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. 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 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.

We've discovered 2 warning signs about 3SBio. View them for free.

The Model

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (CN¥, Millions)	CN¥1.78b	CN¥2.55b	CN¥2.95b	CN¥2.85b	CN¥3.23b	CN¥3.41b	CN¥3.57b	CN¥3.71b	CN¥3.83b	CN¥3.96b
Growth Rate Estimate Source	Analyst x4	Analyst x4	Analyst x4	Analyst x2	Analyst x2	Est @ 5.45%	Est @ 4.55%	Est @ 3.92%	Est @ 3.47%	Est @ 3.16%
Present Value (CN¥, Millions) Discounted @ 6.7%	CN¥1.7k	CN¥2.2k	CN¥2.4k	CN¥2.2k	CN¥2.3k	CN¥2.3k	CN¥2.3k	CN¥2.2k	CN¥2.1k	CN¥2.1k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥22b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (2.4%) 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 6.7%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = CN¥4.0b× (1 + 2.4%) ÷ (6.7%– 2.4%) = CN¥96b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥96b÷ ( 1 + 6.7%)¹⁰= CN¥50b

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¥72b. 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$19.2, the company appears quite good value at a 42% discount to where the stock price trades currently. 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.

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 3SBio 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 6.7%, which is based on a levered beta of 0.804. 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.

View our latest analysis for 3SBio

SWOT Analysis for 3SBio

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess 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?" 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 3SBio, we've put together three important aspects you should further research:

1. Risks: To that end, you should learn about the 2 warning signs we've spotted with 3SBio (including 1 which is a bit concerning) .
2. Future Earnings: How does 1530'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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.