Is There An Opportunity With Sihuan Pharmaceutical Holdings Group Ltd’s (HKG:460) 37.84% Undervaluation?

Mary Ramos

Updated Mon, Jun 25, 2018, 6:55 PM

I am going to run you through how I calculated the intrinsic value of Sihuan Pharmaceutical Holdings Group Ltd (HKG:460) by projecting its future cash flows and then discounting them to today’s value. This is done using the Discounted Cash Flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. If you want to learn more about discounted cash flow, the basis for my calcs can be read in detail in the Simply Wall St analysis model. Please also note that this article was written in June 2018 so be sure check out the updated calculation by following the link below. See our latest analysis for Sihuan Pharmaceutical Holdings Group

Is 460 fairly valued?

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. To start off with we need to estimate the next five years of cash flows. Seeing as no analyst estimates of free cash flow are available I have extrapolated the most recent reported free cash flow (FCF) based on the average annual revenue growth over the past five years. The sum of these cash flows is then discounted to today’s value.

5-year cash flow estimate

2018	2019	2020	2021	2022
Levered FCF (CN¥, Millions)	CN¥1.66k	CN¥1.63k	CN¥1.61k	CN¥1.59k	CN¥1.57k
Source	Extrapolated @ (-1.4%)	Extrapolated @ (-1.4%)	Extrapolated @ (-1.4%)	Extrapolated @ (-1.4%)	Extrapolated @ (-1.4%)
Present Value Discounted @ 8.44%	CN¥1.53k	CN¥1.39k	CN¥1.26k	CN¥1.15k	CN¥1.04k

Present Value of 5-year Cash Flow (PVCF)= HK$6.38b

After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (2.2%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 8.4%.

Terminal Value (TV) = FCF₂₀₂₂ × (1 + g) ÷ (r – g) = HK$1.57b × (1 + 2.2%) ÷ (8.4% – 2.2%) = HK$25.67b

Present Value of Terminal Value (PVTV) = TV / (1 + r)⁵ = HK$25.67b ÷ ( 1 + 8.4%)⁵ = HK$17.12b

The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is HK$23.50b. In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number. This results in an intrinsic value in the company’s reported currency of CN¥2.48. However, 460’s primary listing is in China, and 1 share of 460 in CNY represents 1.206 ( CNY/ HKD) share of DB:TEL1, so the intrinsic value per share in HKD is HK$2.99. Relative to the current share price of HK$1.86, the stock is quite undervalued at a 37.84% discount to what it is available for right now.

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don’t agree with my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Sihuan Pharmaceutical Holdings Group as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 8.4%, which is based on a levered beta of 0.800. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For 460, there are three important factors you should further research:

Financial Health: Does 460 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.
Future Earnings: How does 460’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.
Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of 460? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. The Simply Wall St app conducts a discounted cash flow for every stock on the HKG every 6 hours. If you want to find the calculation for other stocks just search here.

To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned.

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