Is China Resources Pharmaceutical Group Limited (HKG:3320) Trading At A 21% Discount?

Today we will run through one way of estimating the intrinsic value of China Resources Pharmaceutical Group Limited (HKG:3320) by taking the expected future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

View our latest analysis for China Resources Pharmaceutical Group

Is China Resources Pharmaceutical Group fairly valued?

We're 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 a stable growth rate. 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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (HK$, Millions)	HK$2.48b	HK$4.64b	HK$2.92b	HK$2.59b	HK$2.53b	HK$2.49b	HK$2.48b	HK$2.48b	HK$2.49b	HK$2.51b
Growth Rate Estimate Source	Analyst x4	Analyst x2	Analyst x1	Analyst x1	Est @ -2.63%	Est @ -1.4%	Est @ -0.54%	Est @ 0.07%	Est @ 0.49%	Est @ 0.79%
Present Value (HK$, Millions) Discounted @ 8.7%	HK$2.3k	HK$3.9k	HK$2.3k	HK$1.9k	HK$1.7k	HK$1.5k	HK$1.4k	HK$1.3k	HK$1.2k	HK$1.1k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = HK$18b

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 1.5%. We discount the terminal cash flows to today's value at a cost of equity of 8.7%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = HK$2.5b× (1 + 1.5%) ÷ (8.7%– 1.5%) = HK$35b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= HK$35b÷ ( 1 + 8.7%)¹⁰= HK$15b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is HK$34b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of HK$4.3, the company appears a touch undervalued at a 21% 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. 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 China Resources Pharmaceutical 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 8.7%, which is based on a levered beta of 1.366. 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.

Next Steps:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price sitting below the intrinsic value? For China Resources Pharmaceutical Group, we've compiled three fundamental factors you should consider:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with China Resources Pharmaceutical Group (at least 1 which is potentially serious) , and understanding them should be part of your investment process.
2. Future Earnings: How does 3320'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. 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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