Does the April share price for Biotec Pharmacon ASA (OB:BIOTEC) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by estimating the company's future cash flows and discounting them to their present value. This is done using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.
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 use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To begin with, we have to get estimates of the next ten years of cash flows. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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 discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) forecast
|Levered FCF (NOK, Millions)||kr6.18m||kr8.81m||kr11.5m||kr13.9m||kr16.0m||kr17.7m||kr19.1m||kr20.2m||kr21.0m||kr21.6m|
|Growth Rate Estimate Source||Est @ 60.77%||Est @ 42.73%||Est @ 30.11%||Est @ 21.27%||Est @ 15.08%||Est @ 10.75%||Est @ 7.72%||Est @ 5.6%||Est @ 4.12%||Est @ 3.08%|
|Present Value (NOK, Millions) Discounted @ 6.4%||kr5.8||kr7.8||kr9.5||kr10.9||kr11.8||kr12.2||kr12.4||kr12.3||kr12.0||kr11.7|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = kr106m
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 10-year government bond rate of 0.6%. We discount the terminal cash flows to today's value at a cost of equity of 6.4%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = kr22m× (1 + 0.6%) ÷ 6.4%– 0.6%) = kr381m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= kr381m÷ ( 1 + 6.4%)10= kr206m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is kr312m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of kr7.6, the company appears around fair value at the time of writing. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.
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 Biotec Pharmacon 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 6.4%, which is based on a levered beta of 1.051. 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. For Biotec Pharmacon, We've put together three relevant factors you should further research:
- Risks: For example, we've discovered 3 warning signs for Biotec Pharmacon that you should be aware of before investing here.
- Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for BIOTEC'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the OB every day. If you want to find the calculation for other stocks just search here.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned.
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