Stock Analysis

Hansoh Pharmaceutical Group Company Limited's (HKG:3692) Intrinsic Value Is Potentially 65% Above Its Share Price

SEHK:3692
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Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Hansoh Pharmaceutical Group Company Limited (HKG:3692) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

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 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.

Check out our latest analysis for Hansoh Pharmaceutical Group

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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) estimate

2023 2024 2025 2026 2027 2028 2029 2030 2031 2032
Levered FCF (CN¥, Millions) CN¥3.26b CN¥3.91b CN¥5.59b CN¥5.77b CN¥5.91b CN¥6.04b CN¥6.16b CN¥6.28b CN¥6.40b CN¥6.51b
Growth Rate Estimate Source Analyst x7 Analyst x6 Analyst x2 Analyst x2 Est @ 2.48% Est @ 2.22% Est @ 2.04% Est @ 1.91% Est @ 1.83% Est @ 1.76%
Present Value (CN¥, Millions) Discounted @ 6.0% CN¥3.1k CN¥3.5k CN¥4.7k CN¥4.6k CN¥4.4k CN¥4.3k CN¥4.1k CN¥3.9k CN¥3.8k CN¥3.6k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥40b

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 (1.6%) 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 6.0%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = CN¥6.5b× (1 + 1.6%) ÷ (6.0%– 1.6%) = CN¥152b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CN¥152b÷ ( 1 + 6.0%)10= CN¥85b

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¥125b. 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$14.0, the company appears quite undervalued at a 39% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf
SEHK:3692 Discounted Cash Flow October 19th 2022

Important Assumptions

We would point out that 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 Hansoh 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 6.0%, which is based on a levered beta of 0.800. 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 Hansoh Pharmaceutical Group

Strength
  • Debt is not viewed as a risk.
Weakness
  • Earnings growth over the past year underperformed the Pharmaceuticals industry.
  • Dividend is low compared to the top 25% of dividend payers in the Pharmaceuticals market.
Opportunity
  • Annual earnings are forecast to grow faster than the Hong Kong market.
  • Trading below our estimate of fair value by more than 20%.
Threat
  • Revenue is forecast to grow slower than 20% per year.

Moving On:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Can we work out why the company is trading at a discount to intrinsic value? For Hansoh Pharmaceutical Group, we've put together three fundamental factors you should further research:

  1. Financial Health: Does 3692 have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
  2. Future Earnings: How does 3692'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.

Valuation is complex, but we're here to simplify it.

Discover if Hansoh Pharmaceutical Group might be undervalued or overvalued with our detailed analysis, featuring fair value estimates, potential risks, dividends, insider trades, and its financial condition.

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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.