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Are Investors Undervaluing CVS Health Corporation (NYSE:CVS) By 37%?

Today we will run through one way of estimating the intrinsic value of CVS Health Corporation (NYSE:CVS) by taking the forecast future cash flows of the company and discounting them back 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. 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.

Check out our latest analysis for CVS Health

The calculation

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. 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.

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Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

2021

2022

2023

2024

2025

2026

2027

2028

2029

2030

Levered FCF ($, Millions)

US$10.3b

US$11.2b

US$12.0b

US$13.0b

US$13.2b

US$13.5b

US$13.7b

US$14.0b

US$14.3b

US$14.5b

Growth Rate Estimate Source

Analyst x8

Analyst x9

Analyst x6

Analyst x4

Analyst x3

Est @ 1.75%

Est @ 1.84%

Est @ 1.9%

Est @ 1.94%

Est @ 1.97%

Present Value ($, Millions) Discounted @ 9.5%

US$9.4k

US$9.4k

US$9.2k

US$9.0k

US$8.4k

US$7.8k

US$7.3k

US$6.8k

US$6.3k

US$5.8k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$79b

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 5-year average of the 10-year government bond yield (2.0%) 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 9.5%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$15b× (1 + 2.0%) ÷ (9.5%– 2.0%) = US$198b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$198b÷ ( 1 + 9.5%)10= US$80b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$159b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$75.9, the company appears quite good value at a 37% 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.

dcf
dcf

Important assumptions

We would point out that 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 CVS Health 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 9.5%, which is based on a levered beta of 1.433. 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.

Looking Ahead:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For CVS Health, we've put together three important factors you should further research:

  1. Risks: Take risks, for example - CVS Health has 1 warning sign we think you should be aware of.

  2. Future Earnings: How does CVS'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 NYSE every day. If you want to find the calculation for other stocks just search here.

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.

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