Is There An Opportunity With Innovent Biologics, Inc.'s (HKG:1801) 50% Undervaluation?

Key Insights

• The projected fair value for Innovent Biologics is HK$73.98 based on 2 Stage Free Cash Flow to Equity
• Innovent Biologics is estimated to be 50% undervalued based on current share price of HK$37.00
• Our fair value estimate is 46% higher than Innovent Biologics' analyst price target of CN¥50.54

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Innovent Biologics, Inc. (HKG:1801) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

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 still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out our latest analysis for Innovent Biologics

Crunching The Numbers

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 start off with, we need to estimate 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

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (CN¥, Millions)	-CN¥2.10b	-CN¥1.13b	CN¥42.2m	CN¥1.16b	CN¥2.74b	CN¥4.19b	CN¥5.75b	CN¥7.29b	CN¥8.69b	CN¥9.91b
Growth Rate Estimate Source	Analyst x12	Analyst x12	Analyst x9	Analyst x6	Analyst x7	Est @ 52.61%	Est @ 37.37%	Est @ 26.70%	Est @ 19.23%	Est @ 14.00%
Present Value (CN¥, Millions) Discounted @ 7.6%	-CN¥2.0k	-CN¥978	CN¥33.8	CN¥869	CN¥1.9k	CN¥2.7k	CN¥3.4k	CN¥4.1k	CN¥4.5k	CN¥4.8k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥19b

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 (1.8%) 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 7.6%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = CN¥9.9b× (1 + 1.8%) ÷ (7.6%– 1.8%) = CN¥174b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥174b÷ ( 1 + 7.6%)¹⁰= CN¥83b

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¥103b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of HK$37.0, the company appears quite undervalued at a 50% 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.

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Innovent Biologics 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 7.6%, which is based on a levered beta of 0.811. 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.

SWOT Analysis for Innovent Biologics

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. 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. What is the reason for the share price sitting below the intrinsic value? For Innovent Biologics, there are three essential items you should further research:

1. Risks: For example, we've discovered 1 warning sign for Innovent Biologics that you should be aware of before investing here.
2. Future Earnings: How does 1801'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 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.