How far is Sonic Healthcare Limited (ASX: SHL) from its intrinsic value? Using the most recent financial data, we will examine whether the stock price is fair by taking expected future cash flows and discounting them to present value. The DCF (Discounted Cash Flow) model is the tool we will apply to do this. Patterns like these may seem beyond a layman’s comprehension, but they are easy enough to follow.
There are many ways that businesses can be valued, so we would like to stress that a DCF is not perfect for every situation. If you want to know more about discounted cash flow, the rationale for this calculation can be read in detail in the Simply Wall St.
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Is Sonic Healthcare valued?
We are going to use a two-step DCF model which, as the name suggests, takes into account two growth stages. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “steady growth”. To begin with, we need to get cash flow estimates for the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous Free Cash Flow (FCF) from the last estimate or last published value. We assume that companies with decreasing free cash flow will slow their withdrawal rate, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect that growth tends to slow down more in the early years than in the following years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we discount the value of those future cash flows to their estimated value in today’s dollars:
10-year Free Cash Flow (FCF) forecast
|Leverage FCF (A $, millions)||AU $ 869.4M||AU $ 835.3M||A $ 902.0 million||A $ 876.4M||A $ 771.5M||A $ 762.9M||A $ 762.1M||A $ 766.7M||A $ 775.2M||A $ 786.4M|
|Source of estimated growth rate||Analyst x4||Analyst x4||Analyst x4||Analyst x3||Analyst x2||Is at -1.12%||East @ -0.1%||Is 0.61%||Is 1.1%||Is 1.45%|
|Present value (A $, millions) discounted at 7.4%||AU $ 809||AU $ 724||A $ 728||AU $ 658||AU $ 539||497 AU $||A $ 462||AU $ 433||407 AU $||A $ 384|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flow (PVCF) = 5.6 billion Australian dollars
After calculating the present value of future cash flows over the initial 10 year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first step. 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 used the 5-year average of the 10-year government bond yield (2.3%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 7.4%.
Terminal value (TV)= FCF2030 × (1 + g) ÷ (r – g) = AU $ 786 million × (1 + 2.3%) ÷ (7.4% – 2.3%) = AU $ 16 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= AU $ 16 billion ÷ (1 + 7.4%)ten= 7.6 billion Australian dollars
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is AU $ 13 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of AU $ 33.8, the company appears to be slightly overvalued at the time of writing. Assumptions in any calculation have a big impact on the valuation, so it’s best to think of this as a rough estimate, not precise down to the last penny.
The above calculation is very dependent on two assumptions. One is the discount rate and the other is cash flow. Part of investing is making your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a full picture of a company’s potential performance. Since we view Sonic 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 takes into account debt. In this calculation, we used 7.4%, which is based on a leveraged beta of 0.858. Beta is a measure of the volatility of a stock, relative 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.
To move on:
Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn’t be the only metric you look at when researching a business. The DCF model is not a perfect equity valuation tool. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. For example, if the terminal value growth rate is adjusted slightly, it can significantly change the overall result. Can we understand why the company trades at a premium over its intrinsic value? For Sonic Healthcare, we’ve put together three relevant things you should dig deeper into:
- Risks: For example, we discovered 2 warning signs for Sonic Healthcare which you should be aware of before investing here.
- Future income: How does SHL’s growth rate compare to its peers and the market in general? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth forecast chart.
- Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high quality inventory to get a feel for what you might be missing!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for each ASX share. If you want to find the calculation for other actions, just search here.
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This Simply Wall St article is general in nature. It is not a recommendation to buy or sell any stock, and does not take into account your goals or your financial situation. We aim to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative information. Simply Wall St has no position in the mentioned stocks.
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