Are Investors Undervaluing Hansoh Pharmaceutical Group Company Limited (HKG:3692) By 27%?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Hansoh Pharmaceutical Group fair value estimate is HK$52.95
• Hansoh Pharmaceutical Group is estimated to be 27% undervalued based on current share price of HK$38.58
• Our fair value estimate is 17% higher than Hansoh Pharmaceutical Group's analyst price target of CN¥45.31

How far off is Hansoh Pharmaceutical Group Company Limited (HKG:3692) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

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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. To start off with, we need to estimate the next ten years of cash flows. 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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

	2026	2027	2028	2029	2030	2031	2032	2033	2034	2035
Levered FCF (CN¥, Millions)	CN¥4.94b	CN¥6.24b	CN¥8.06b	CN¥9.65b	CN¥11.5b	CN¥13.0b	CN¥14.2b	CN¥15.3b	CN¥16.2b	CN¥17.0b
Growth Rate Estimate Source	Analyst x8	Analyst x8	Analyst x4	Analyst x3	Analyst x3	Est @ 12.35%	Est @ 9.49%	Est @ 7.49%	Est @ 6.09%	Est @ 5.11%
Present Value (CN¥, Millions) Discounted @ 7.0%	CN¥4.6k	CN¥5.4k	CN¥6.6k	CN¥7.4k	CN¥8.2k	CN¥8.6k	CN¥8.8k	CN¥8.9k	CN¥8.8k	CN¥8.6k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CN¥76b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.8%. We discount the terminal cash flows to today's value at a cost of equity of 7.0%.

Terminal Value (TV)= FCF₂₀₃₅ × (1 + g) ÷ (r – g) = CN¥17b× (1 + 2.8%) ÷ (7.0%– 2.8%) = CN¥417b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= CN¥417b÷ ( 1 + 7.0%)¹⁰= CN¥211b

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¥287b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of HK$38.6, the company appears a touch undervalued at a 27% 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.

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 7.0%, 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.

Check out our latest analysis for Hansoh Pharmaceutical Group

SWOT Analysis for Hansoh Pharmaceutical Group

Next Steps:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. 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. Why is the intrinsic value higher than the current share price? For Hansoh Pharmaceutical Group, we've put together three further factors you should assess:

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 Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

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

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.