Luye Pharma Group Ltd.'s (HKG:2186) Intrinsic Value Is Potentially 20% Below Its Share Price

Key Insights

• Luye Pharma Group's estimated fair value is HK$2.47 based on 2 Stage Free Cash Flow to Equity
• Current share price of HK$3.09 suggests Luye Pharma Group is potentially 25% overvalued
• Our fair value estimate is 30% lower than Luye Pharma Group's analyst price target of CN¥3.53

Does the August share price for Luye Pharma Group Ltd. (HKG:2186) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected 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. It may sound complicated, but actually it is quite simple!

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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

View our latest analysis for Luye Pharma Group

Crunching The Numbers

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. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (CN¥, Millions)	CN¥236.2m	CN¥293.6m	CN¥345.1m	CN¥389.4m	CN¥426.6m	CN¥457.6m	CN¥483.4m	CN¥505.2m	CN¥524.0m	CN¥540.6m
Growth Rate Estimate Source	Est @ 33.86%	Est @ 24.27%	Est @ 17.55%	Est @ 12.85%	Est @ 9.56%	Est @ 7.25%	Est @ 5.64%	Est @ 4.51%	Est @ 3.72%	Est @ 3.17%
Present Value (CN¥, Millions) Discounted @ 6.8%	CN¥221	CN¥257	CN¥283	CN¥299	CN¥307	CN¥309	CN¥305	CN¥299	CN¥290	CN¥280

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥2.9b

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 1.9%. We discount the terminal cash flows to today's value at a cost of equity of 6.8%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = CN¥541m× (1 + 1.9%) ÷ (6.8%– 1.9%) = CN¥11b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥11b÷ ( 1 + 6.8%)¹⁰= CN¥5.8b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is CN¥8.7b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of HK$3.1, the company appears slightly overvalued at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Luye Pharma 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 6.8%, which is based on a levered beta of 0.808. 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 Luye Pharma Group

Next Steps:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. 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 premium to intrinsic value? For Luye Pharma Group, we've put together three essential factors you should further research:

1. Risks: We feel that you should assess the 1 warning sign for Luye Pharma Group we've flagged before making an investment in the company.
2. Future Earnings: How does 2186'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. 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.