How far off is Sonic Healthcare Limited (ASX:SHL) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the forecast future cash flows of the company and discounting them back to today's 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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
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.
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) estimate
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
Levered FCF (A$, Millions)
AU$883.3m
AU$980.7m
AU$1.06b
AU$1.08b
AU$1.14b
AU$1.18b
AU$1.22b
AU$1.25b
AU$1.29b
AU$1.32b
Growth Rate Estimate Source
Analyst x7
Analyst x7
Analyst x6
Analyst x2
Analyst x2
Est @ 3.82%
Est @ 3.28%
Est @ 2.90%
Est @ 2.63%
Est @ 2.44%
Present Value (A$, Millions) Discounted @ 6.0%
AU$833
AU$873
AU$886
AU$856
AU$849
AU$831
AU$810
AU$786
AU$761
AU$735
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = AU$8.2b
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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 6.0%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$34b÷ ( 1 + 6.0%)10= AU$19b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$27b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of AU$28.8, the company appears quite undervalued at a 49% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
ASX:SHL Discounted Cash Flow October 30th 2023
The Assumptions
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 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 accounts for debt. In this calculation we've used 6.0%, 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 Sonic Healthcare
Strength
Debt is not viewed as a risk.
Dividends are covered by earnings and cash flows.
Weakness
Earnings declined over the past year.
Dividend is low compared to the top 25% of dividend payers in the Healthcare market.
Opportunity
Annual revenue is forecast to grow faster than the Australian market.
Good value based on P/E ratio and estimated fair value.
Threat
Annual earnings are forecast to grow slower than the Australian market.
Looking Ahead:
Although the valuation of a company is important, 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. 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. Why is the intrinsic value higher than the current share price? For Sonic Healthcare, we've compiled three relevant factors you should consider:
Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for SHL'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. Simply Wall St updates its DCF calculation for every Australian stock every day, so if you want to find the intrinsic value of any other stock 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.
