The intrinsic value of Guangzhou Baiyunshan Pharmaceutical Holdings Company Limited (HKG:874) is potentially 83% higher than its share price
Does the April share price of Guangzhou Baiyunshan Pharmaceutical Holdings Company Limited (HKG:874) reflect what it is really worth? Today we are going to estimate the intrinsic value of the stock by taking the expected future cash flows of the business and discounting them to the present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. This may sound complicated, but it’s actually quite simple!
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. Anyone interested in learning a little more about intrinsic value should read the Simply Wall St.
See our latest analysis for Guangzhou Baiyunshan Pharmaceutical Holdings
Step by step in the calculation
We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “sustained growth”. To begin with, we need to obtain cash flow estimates for the next ten years. Since no analyst estimate of free cash flow is available, we have extrapolated the previous free cash flow (FCF) from the company’s latest 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 discount the value of these future cash flows to their estimated value in today’s dollars:
10-Year Free Cash Flow (FCF) Forecast
|Leveraged FCF (CN¥, Million)||CN¥2.81b||CN¥2.53b||CN¥2.37b||CN¥2.27b||CN¥2.22b||CN¥2.19b||CN¥2.18b||CN¥2.18b||CN¥2.19b||CN¥2.21b|
|Growth rate estimate Source||East @ -14.68%||Is @ -9.84%||Is @ -6.44%||East @ -4.06%||Is @ -2.4%||Is @ -1.24%||Is @ -0.42%||Is 0.15%||Is at 0.55%||Is at 0.83%|
|Present value (CN¥, million) discounted at 5.4%||CN¥2.7k||CN¥2.3k||CN¥2.0k||CN¥1.8k||CN¥1.7k||CN¥1.6k||CN¥1.5k||CN¥1.4k||CN¥1.4k||CN¥1.3k|
We now need to calculate the terminal value, which represents all future cash flows after this ten-year period. 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¥2.2b × (1 + 1.5%) ÷ (5.4%–1.5%) = CN¥57b
Present value of terminal value (PVTV)= TV / (1 + r)ten= CN¥57b÷ ( 1 + 5.4%)ten= CN¥33b
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is 51 billion yen. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of HK$20.6, the company appears to have good value at a 45% discount to the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in a different galaxy. Keep that in mind.
The above calculation is highly dependent on two assumptions. One is the discount rate and the other is the cash flows. If you disagree with these results, try the math yourself and play around with the 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 Guangzhou Baiyunshan Pharmaceutical Holdings 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 0.802. 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.
Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won’t be the only piece of analysis you look at for a company. DCF models are not the be-all and end-all of investment valuation. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under/overvalued?” For example, if the terminal value growth rate is adjusted slightly, it can significantly change the overall result. Can we understand why the company is trading at a discount to its intrinsic value? For Guangzhou Baiyunshan Pharmaceutical Holdings, we’ve rounded up three additional things you should evaluate:
- Risks: Take for example the ubiquitous specter of investment risk. We have identified 1 warning sign with Guangzhou Baiyunshan Pharmaceutical Holdings, and understanding this should be part of your investment process.
- Future earnings: How does 874’s growth rate 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.
- Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of what you might be missing!
PS. The Simply Wall St app performs an updated cash flow assessment 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.