A look at the fair value of Henan Lingrui Pharmaceutical Co., Ltd. (SHSE:600285)

Key findings

• The forecast fair value for Henan Lingrui Pharmaceutical is CN¥24.31 based on the 2-step Free Cash Flow to Equity
• Henan Lingrui Pharmaceutical’s share price of CNY 25.12 suggests that the price is at a similar level to the estimated fair value.
• The industry average of 128% suggests that Henan Lingrui Pharmaceutical’s competitors are currently trading at a higher premium to fair value

How far is Henan Lingrui Pharmaceutical Co., Ltd. (SHSE:600285) from its intrinsic value? Using the most recent financial data, we will check whether the stock is fairly valued by taking the expected future cash flows and discounting them to today’s value. Our analysis will use the Discounted Cash Flow (DCF) model. Don’t be put off by the technical jargon, the math behind it is 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 valuation metric among many, and it is not without its flaws. Anyone interested in learning more about intrinsic value should check out Simply Wall St’s analysis model.

Check out our latest analysis for Henan Lingrui Pharmaceutical

Is Henan Lingrui Pharmaceutical fairly valued?

We use the 2-stage growth model, which simply means we consider two stages of company growth. In the early stage, the company may have a higher growth rate, and in the second stage, a stable growth rate is usually assumed. First, we need to estimate the next ten years’ cash flows. Since we don’t have analyst estimates of free cash flow available, we extrapolated the previous free cash flow (FCF) from the company’s last reported value. We assume that companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will slow their growth rate over this period. We do this to take into account that growth tends to slow down more in the early years than in later years.

In general, we assume that a dollar today is worth more than a dollar in the future. Therefore, the sum of these future cash flows is discounted to today’s value:

Estimation of free cash flow (FCF) over 10 years

(“Est” = FCF growth rate, estimated by Simply Wall St)
Present value of 10-year cash flow (PVCF) = 4.9 billion CNY

The second period is also called the terminal value. This is the company’s cash flow after the first period. For various reasons, a very conservative growth rate is used, which cannot exceed a country’s GDP growth. In this case, we used the 5-year average of the 10-year Treasury yield (2.9%) 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 7.4%.

Final value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = CN¥784m × (1 + 2.9%) ÷ (7.4% – 2.9%) = CN¥18b

Present value of terminal value (PVTV)= TV / (1 + r)¹⁰= CN¥18b÷ ( 1 + 7.4 %)¹⁰= 8.8 billion CNY

Total value is the sum of the next ten years’ cash flows plus the discounted terminal value, which gives the total value of equity, which in this case is CNY14 billion. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of CNY25.1, the company is about fair value at the time of writing. However, keep in mind that this is only an approximate valuation and as with any complex formula, where there’s garbage in, there’s garbage out.

The assumptions

The above calculation heavily relies on two assumptions. The first is the discount rate and the other is the cash flows. If you disagree with these results, try the calculation yourself and play with the assumptions. DCF also does not take into account the possible cyclicality of an industry or a company’s future capital needs and therefore does not provide a complete picture of a company’s potential performance. Since we consider Henan Lingrui Pharmaceutical 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 7.4% which is based on a levered beta of 0.800. Beta is a measure of a stock’s volatility relative to the overall market. We get our beta from the industry average beta of globally comparable companies with an imposed limit of between 0.8 and 2.0, which is a reasonable range for a stable company.

Go on:

While valuing a company is important, ideally it shouldn’t be the only analysis you look at for a company. The DCF model is not a perfect tool for stock valuation. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to an undervaluation or overvaluation of the company. If a company grows differently or its cost of equity or risk-free rate changes significantly, the outcome may be very different. For Henan Lingrui Pharmaceutical, we’ve put together three basic aspects to consider:

1. Risks: Note that Henan Lingrui Pharmaceutical shows 1 warning signal in our investment analysis you should know about…
2. Future income: How does the growth rate of 600285 compare to its competitors and the overall market? Learn more about analyst consensus numbers for the coming years by using our free chart of analyst growth expectations.
3. Other high-quality alternatives: Like a good all-rounder? Explore our interactive list of high-quality stocks to get a sense of what else you might be missing out on!

PS. Simply Wall St updates its DCF calculation for each Chinese stock daily, so if you want to find out the intrinsic value of another stock, just search here.

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This Simply Wall St article is of a general nature. We comment solely on historical data and analyst forecasts, using an unbiased methodology. Our articles do not constitute financial advice. It is not a recommendation to buy or sell any stock and does not take into account your objectives or financial situation. Our goal is to provide you with long-term analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative materials. Simply Wall St does not hold any of the stocks mentioned.

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