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Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Genix Pharmaceuticals Corporation (CVE:GENX) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. 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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
Crunching the numbers
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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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 (CA$, Millions)||CA$110.3k||CA$191.5k||CA$291.2k||CA$398.6k||CA$503.6k||CA$598.9k||CA$681.2k||CA$750.2k||CA$807.1k||CA$853.9k|
|Growth Rate Estimate Source||Est @ 104.41%||Est @ 73.59%||Est @ 52.01%||Est @ 36.9%||Est @ 26.33%||Est @ 18.93%||Est @ 13.75%||Est @ 10.12%||Est @ 7.58%||Est @ 5.81%|
|Present Value (CA$, Millions) Discounted @ 6.6%||CA$0.1||CA$0.2||CA$0.2||CA$0.3||CA$0.4||CA$0.4||CA$0.4||CA$0.4||CA$0.5||CA$0.4|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = CA$3.0m
The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 have used the 5-year average of the 10-year government bond yield (1.7%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 6.6%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = CA$854k× (1 + 1.7%) ÷ (6.6%– 1.7%) = CA$17m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= CA$17m÷ ( 1 + 6.6%)10= CA$9.2m
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is CA$12m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of CA$0.2, 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.
We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual 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 Genix 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 6.6%, which is based on a levered beta of 0.828. 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, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Genix Pharmaceuticals, there are three essential aspects you should look at:
- Risks: As an example, we've found 5 warning signs for Genix Pharmaceuticals (3 shouldn't be ignored!) that you need to consider before investing here.
- 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!
- Other Top Analyst Picks: Interested to see what the analysts are thinking? Take a look at our interactive list of analysts' top stock picks to find out what they feel might have an attractive future outlook!
PS. Simply Wall St updates its DCF calculation for every Canadian stock every day, so if you want to find the intrinsic value of any other stock just search here.
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. 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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