Is Vertex Pharmaceuticals Incorporated (NASDAQ:VRTX) Trading At A 23% Discount?

Key Insights

• Vertex Pharmaceuticals' estimated fair value is US$431 based on 2 Stage Free Cash Flow to Equity

• Current share price of US$334 suggests Vertex Pharmaceuticals is potentially 23% undervalued

• Analyst price target for VRTX is US$372 which is 14% below our fair value estimate

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Vertex Pharmaceuticals Incorporated (NASDAQ:VRTX) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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.

See our latest analysis for Vertex Pharmaceuticals

Is Vertex Pharmaceuticals Fairly Valued?

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 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

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	US$3.41b	US$3.92b	US$4.39b	US$4.84b	US$5.34b	US$5.72b	US$6.03b	US$6.30b	US$6.54b	US$6.76b
Growth Rate Estimate Source	Analyst x8	Analyst x8	Analyst x7	Analyst x7	Analyst x7	Est @ 7.00%	Est @ 5.53%	Est @ 4.51%	Est @ 3.79%	Est @ 3.28%
Present Value ($, Millions) Discounted @ 6.9%	US$3.2k	US$3.4k	US$3.6k	US$3.7k	US$3.8k	US$3.8k	US$3.8k	US$3.7k	US$3.6k	US$3.5k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$36b

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 5-year average of the 10-year government bond yield of 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 6.9%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$6.8b× (1 + 2.1%) ÷ (6.9%– 2.1%) = US$145b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$145b÷ ( 1 + 6.9%)¹⁰= US$75b

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$111b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$334, the company appears a touch undervalued at a 23% 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

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Vertex Pharmaceuticals 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 6.9%, which is based on a levered beta of 0.800. 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.

SWOT Analysis for Vertex Pharmaceuticals

Strength

• Earnings growth over the past year exceeded the industry.

• Currently debt free.

Weakness

• No major weaknesses identified for VRTX.

Opportunity

• Annual earnings are forecast to grow for the next 3 years.

• Trading below our estimate of fair value by more than 20%.

Threat

• Annual earnings are forecast to grow slower than the American market.

Moving On:

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. DCF models are not the be-all and end-all of investment valuation. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Why is the intrinsic value higher than the current share price? For Vertex Pharmaceuticals, we've compiled three important aspects you should look at:

1. Financial Health: Does VRTX 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 VRTX'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 NASDAQGS every day. If you want to find the calculation for other stocks just search here.

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

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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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