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Investors Are Undervaluing Hengan International Group Company Limited (HKG:1044) By 27.04%

I am going to run you through how I calculated the intrinsic value of Hengan International Group Company Limited (HKG:1044) by estimating the company’s future cash flows and discounting them to their present value. I will be using the discounted cash flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. Please also note that this article was written in October 2018 so be sure check out the updated calculation by following the link below.

Check out our latest analysis for Hengan International Group

Crunching the numbers

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. In the first stage we need to estimate the cash flows to the business over the next five years. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount this to its value today and sum up the total to get the present value of these cash flows.

5-year cash flow forecast

2019

2020

2021

2022

2023

Levered FCF (CN¥, Millions)

CN¥4.05k

CN¥4.64k

CN¥6.71k

CN¥7.07k

CN¥7.32k

Source

Analyst x10

Analyst x9

Analyst x2

Analyst x2

Est @ 3.66%

Present Value Discounted @ 8.44%

CN¥3.73k

CN¥3.95k

CN¥5.26k

CN¥5.11k

CN¥4.88k

Present Value of 5-year Cash Flow (PVCF)= CN¥22.9b

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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 an annual growth rate equal to the 10-year government bond rate of 2.2%. We discount this to today’s value at a cost of equity of 8.4%.

Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = CN¥7.3b × (1 + 2.2%) ÷ (8.4% – 2.2%) = CN¥120.0b

Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = CN¥120.0b ÷ ( 1 + 8.4%)5 = CN¥80.0b

The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is CN¥103.0b. 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¥85.37. However, 1044’s primary listing is in China, and 1 share of 1044 in CNY represents 1.141 ( CNY/ HKD) share of OTCPK:HEGI.F, so the intrinsic value per share in HKD is HK$97.38. Compared to the current share price of HK$71.05, the stock is about right, perhaps slightly undervalued at a 27% discount to what it is available for right now.

SEHK:1044 Intrinsic Value Export October 3rd 18
SEHK:1044 Intrinsic Value Export October 3rd 18

The 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 my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Hengan International 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:

Although the valuation of a company is important, 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 1044, I’ve put together three important aspects you should look at:

  1. Financial Health: Does 1044 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 1044’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 High Quality Alternatives: Are there other high quality stocks you could be holding instead of 1044? 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 past 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. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.