In this article, we will estimate the intrinsic value of Sino Biopharmaceutical Limited (HKG:1177) by taking expected future cash flows and discounting them to their present value. On this occasion, we will use the Discounted Cash Flow (DCF) model. Before you think you can’t figure it out, just read on! It’s actually a lot less complex than you might imagine.

We generally believe that the value of a company is the present value of all the cash it will generate in the future. However, a DCF is just one of many evaluation metrics, and it is not without its flaws. If you still have burning questions about this type of assessment, take a look at Simply Wall St.’s analysis template.

Discover our latest analysis for Sino Biopharmaceutical

The model

We use the 2-stage growth model, which simply means that we consider two stages of business growth. In the initial period, the company may have a higher growth rate, and the second stage is generally assumed to have a stable growth rate. To start, we need to estimate the cash flows for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.

Generally, we assume that a dollar today is worth more than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at an estimate of present value:

Estimated free cash flow (FCF) over 10 years

(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = CN¥50b

After calculating the present value of future cash flows over the initial 10-year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first stage. For a number of reasons, a very conservative growth rate is used which cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (1.5%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 5.4%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = CN¥7.8b × (1 + 1.5%) ÷ (5.4%–1.5%) = CN¥202b

Present value of terminal value (PVTV)= TV / (1 + r)^ten= CN¥202b÷ ( 1 + 5.4%)^ten= CN¥119b

The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is 169 billion Canadian yen. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of HK$6.1, the company appears to have good value at a 45% discount to the current share price. The assumptions of any calculation have a big impact on the valuation, so it’s best to consider this as a rough estimate, not accurate down to the last penny.

The hypotheses

The above calculation is highly dependent on two assumptions. One is the discount rate and the other is the cash flows. Part of investing is coming up with your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Sino Biopharmaceutical 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 takes debt into account. In this calculation, we used 5.4%, which is based on a leveraged beta of 0.800. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

Look forward:

While important, calculating DCF shouldn’t be the only metric to consider when researching a business. It is not possible to obtain an infallible valuation with a DCF model. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under/overvalued?” For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on the valuation. Why is intrinsic value higher than the current stock price? For Sino Biopharmaceutical, there are three relevant things you need to consider:

1. Risks: You should be aware of the 1 warning sign for Sino Biopharmaceutical we found out before considering an investment in the business.
2. Future earnings: How does the growth rate of 1177 compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
3. Other strong companies: Low debt, high returns on equity and good past performance are essential to a strong business. Why not explore our interactive list of stocks with strong trading fundamentals to see if there are any other companies you may not have considered!

PS. The Simply Wall St app performs an updated cash flow valuation for each SEHK stock every day. If you want to find the calculation for other stocks, search here.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.