In this article we are going to estimate the intrinsic value of Union Medical Healthcare Limited (HKG:2138) by taking the forecast future cash flows of the company and discounting them back to today’s value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Models like these may appear beyond the comprehension of a lay person, but they’re fairly easy to follow.
We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis 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 begin with, we have to get estimates of 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.
Generally we assume that a dollar today is more valuable than a dollar in the future, 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
|Levered FCF (HK$, Millions)||-HK$225.6m||HK$413.0m||HK$480.7m||HK$491.8m||HK$502.1m||HK$511.6m||HK$520.8m||HK$529.6m||HK$538.4m||HK$547.0m|
|Growth Rate Estimate Source||Analyst x1||Analyst x1||Analyst x1||Est @ 2.32%||Est @ 2.08%||Est @ 1.91%||Est @ 1.79%||Est @ 1.7%||Est @ 1.65%||Est @ 1.61%|
|Present Value (HK$, Millions) Discounted @ 7.0%||-HK$211||HK$361||HK$392||HK$375||HK$358||HK$341||HK$324||HK$308||HK$293||HK$278|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = HK$2.8b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 1.5%. We discount the terminal cash flows to today’s value at a cost of equity of 7.0%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = HK$547m× (1 + 1.5%) ÷ (7.0%– 1.5%) = HK$10b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= HK$10b÷ ( 1 + 7.0%)10= HK$5.1b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is HK$8.0b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of HK$7.5, the company appears around fair value at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
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 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 Union Medical Healthcare 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 0.897. 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.
Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. It’s not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to “what assumptions need to be true for this stock to be under/overvalued?” For example, changes in the company’s cost of equity or the risk free rate can significantly impact the valuation. For Union Medical Healthcare, we’ve put together three fundamental factors you should assess:
- Risks: Be aware that Union Medical Healthcare is showing 4 warning signs in our investment analysis , you should know about…
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for 2138’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. Simply Wall St updates its DCF calculation for every Hong Kong stock every day, so if you want to find the intrinsic value of any other stock just search here.
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This article by Simply Wall St is general in nature. 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.
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