Today we'll do a simple run through of a valuation method used to estimate the attractiveness of MERCK Kommanditgesellschaft auf Aktien (ETR:MRK) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. I will use the Discounted Cash Flow (DCF) model. 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.
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 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.
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
|Levered FCF (€, Millions)||€2.34b||€2.59b||€2.19b||€2.45b||€2.45b||€2.45b||€2.45b||€2.45b||€2.46b||€2.46b|
|Growth Rate Estimate Source||Analyst x11||Analyst x9||Analyst x1||Analyst x1||Est @ -0.12%||Est @ -0.02%||Est @ 0.06%||Est @ 0.11%||Est @ 0.14%||Est @ 0.17%|
|Present Value (€, Millions) Discounted @ 5.4%||€2.2k||€2.3k||€1.9k||€2.0k||€1.9k||€1.8k||€1.7k||€1.6k||€1.5k||€1.5k|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = €18b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 10-year government bond rate of 0.2%. We discount the terminal cash flows to today's value at a cost of equity of 5.4%.
Terminal Value (TV)= FCF2019 × (1 + g) ÷ (r – g) = €2.5b× (1 + 0.2%) ÷ 5.4%– 0.2%) = €48b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= €48b÷ ( 1 + 5.4%)10= €28b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is €46b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of €104, the company appears about fair value at a 2.5% 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.
Now 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 MERCK Kommanditgesellschaft auf Aktien 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 5.4%, which is based on a levered beta of 0.870. 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.
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 company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/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. For MERCK Kommanditgesellschaft auf Aktien, There are three essential factors you should look at:
- Financial Health: Does MRK 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.
- Future Earnings: How does MRK'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.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of MRK? 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 valuation for every stock on the XTRA every day. If you want to find the calculation for other stocks just search here.
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If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.