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# Calculating The Fair Value Of The a2 Milk Company Limited (NZSE:ATM)

Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of The a2 Milk Company Limited (NZSE:ATM) as an investment opportunity by taking the expected future cash flows and discounting them to todayâ€™s value. This is done using the discounted cash flows (DCF) model. Donâ€™t get put off by the jargon, the math behind it is actually quite straightforward. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. If you are reading this and its not January 2019 then I highly recommend you check out the latest calculation for a2 Milk by following the link below.

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### The method

I use what is known as a 2-stage model, which simply means we have two different periods of varying growth rates for the companyâ€™s cash flows. Generally the first stage is higher growth, and the second stage is a more stable growth phase. In the first stage we need to estimate the cash flows to the business over the next five years. For this I used the consensus of the analysts covering the stock, as you can see below. The sum of these cash flows is then discounted to todayâ€™s value.

#### 5-year cash flow forecast

 2019 2020 2021 2022 2023 Levered FCF (NZ\$, Millions) NZ\$232.59 NZ\$300.75 NZ\$370.84 NZ\$438.56 NZ\$500.94 Source Analyst x4 Analyst x4 Analyst x4 Analyst x2 Analyst x2 Present Value Discounted @ 8.47% NZ\$214.42 NZ\$255.59 NZ\$290.55 NZ\$316.76 NZ\$333.55

Present Value of 5-year Cash Flow (PVCF)= NZ\$1.4b

After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (2.4%). In the same way as with the 5-year â€˜growthâ€™ period, we discount this to todayâ€™s value at a cost of equity of 8.5%.

Terminal Value (TV) = FCF2023 Ã— (1 + g) Ã· (r â€“ g) = NZ\$501m Ã— (1 + 2.4%) Ã· (8.5% â€“ 2.4%) = NZ\$8.4b

Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = NZ\$8.4b Ã· ( 1 + 8.5%)5 = NZ\$5.6b

The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is NZ\$7.0b. The last step is to then divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) then we use the equivalent number. This results in an intrinsic value of NZ\$9.51. Relative to the current share price of NZ\$11.35, the stock is fair value, maybe slightly overvalued at the time of writing.

### The assumptions

Iâ€™d like to point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. You donâ€™t have to agree with my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at a2 Milk as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation Iâ€™ve used 8.5%, which is based on a levered beta of 0.800. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

### Next Steps:

Although the valuation of a company is important, it shouldnâ€™t be the only metric you look at when researching a company. For ATM, there are three important aspects you should look at:

1. Financial Health: Does ATM 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 ATMâ€™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 High Quality Alternatives: Are there other high quality stocks you could be holding instead of ATM? 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 for every stock on the NZSE every 6 hours. If you want to find the calculation for other stocks just search here.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.