Today we will run through one way of estimating the intrinsic value of Recipharm AB (publ) (STO:RECI B) by taking the expected future cash flows and discounting them to their present value. This is done using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
Step by step through the calculation
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, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) forecast
|Levered FCF (SEK, Millions)||kr604.0m||kr1.14b||kr1.14b||kr1.13b||kr1.14b||kr1.14b||kr1.14b||kr1.14b||kr1.15b||kr1.15b|
|Growth Rate Estimate Source||Analyst x1||Analyst x2||Analyst x2||Est @ -0.14%||Est @ 0.05%||Est @ 0.18%||Est @ 0.28%||Est @ 0.34%||Est @ 0.38%||Est @ 0.42%|
|Present Value (SEK, Millions) Discounted @ 8.9%||kr555||kr963||kr881||kr808||kr743||kr684||kr630||kr580||kr535||kr494|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = kr6.9b
The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 10-year government bond rate (0.5%) 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 8.9%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = kr1.2b× (1 + 0.5%) ÷ 8.9%– 0.5%) = kr14b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= kr14b÷ ( 1 + 8.9%)10= kr5.9b
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is kr13b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of kr107, the company appears quite good value at a 43% discount to where the stock price trades currently. 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.
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Recipharm 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 8.9%, which is based on a levered beta of 1.391. 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.
Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. What is the reason for the share price to differ from the intrinsic value? For Recipharm, We've compiled three fundamental aspects you should further research:
- Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 4 warning signs with Recipharm (at least 1 which is concerning) , and understanding these should be part of your investment process.
- Future Earnings: How does RECI B'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 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. Simply Wall St updates its DCF calculation for every SE 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. Thank you for reading.