An Intrinsic Calculation For TOT BIOPHARM International Company Limited (HKG:1875) Suggests It's 41% Undervalued

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of TOT BIOPHARM International Company Limited (HKG:1875) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. There's really not all that much to it, even though it might appear quite complex.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for TOT BIOPHARM International

The model

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 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, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (CN¥, Millions)	-CN¥417.0m	-CN¥252.0m	-CN¥54.0m	CN¥56.0m	CN¥125.0m	CN¥187.0m	CN¥252.7m	CN¥316.1m	CN¥373.0m	CN¥421.6m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Analyst x1	Analyst x1	Analyst x1	Est @ 49.58%	Est @ 35.16%	Est @ 25.07%	Est @ 18%	Est @ 13.05%
Present Value (CN¥, Millions) Discounted @ 7.6%	-CN¥388	-CN¥218	-CN¥43.4	CN¥41.8	CN¥86.8	CN¥121	CN¥152	CN¥176	CN¥193	CN¥203

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥324m

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. 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 7.6%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = CN¥422m× (1 + 1.5%) ÷ (7.6%– 1.5%) = CN¥7.1b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥7.1b÷ ( 1 + 7.6%)¹⁰= CN¥3.4b

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¥3.7b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of HK$4.3, the company appears quite good value at a 41% 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

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 TOT BIOPHARM International 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 0.969. 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:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching 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. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Why is the intrinsic value higher than the current share price? For TOT BIOPHARM International, we've put together three pertinent items you should further research:

1. Risks: You should be aware of the 4 warning signs for TOT BIOPHARM International (2 are a bit unpleasant!) we've uncovered before considering an investment in the company.
2. Future Earnings: How does 1875'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. 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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