An Intrinsic Calculation For Neuren Pharmaceuticals Limited (ASX:NEU) Suggests It's 44% Undervalued

Key Insights

• The projected fair value for Neuren Pharmaceuticals is AU$43.02 based on 2 Stage Free Cash Flow to Equity

• Current share price of AU$24.04 suggests Neuren Pharmaceuticals is potentially 44% undervalued

• Analyst price target for NEU is AU$26.43 which is 39% below our fair value estimate

Today we will run through one way of estimating the intrinsic value of Neuren Pharmaceuticals Limited (ASX:NEU) by taking the expected future cash flows and discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. It may sound complicated, but actually it is quite simple!

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.

See our latest analysis for Neuren Pharmaceuticals

The Calculation

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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$28.8m	AU$124.9m	AU$156.7m	AU$185.6m	AU$210.7m	AU$232.0m	AU$249.9m	AU$264.9m	AU$277.7m	AU$288.8m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Est @ 25.46%	Est @ 18.45%	Est @ 13.54%	Est @ 10.10%	Est @ 7.69%	Est @ 6.01%	Est @ 4.83%	Est @ 4.01%
Present Value (A$, Millions) Discounted @ 6.1%	AU$27.1	AU$111	AU$131	AU$147	AU$157	AU$163	AU$165	AU$165	AU$163	AU$160

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$1.4b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 6.1%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$289m× (1 + 2.1%) ÷ (6.1%– 2.1%) = AU$7.4b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$7.4b÷ ( 1 + 6.1%)¹⁰= AU$4.1b

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 AU$5.5b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of AU$24.0, the company appears quite undervalued at a 44% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

ASX:NEU Discounted Cash Flow December 26th 2023

The Assumptions

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. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Neuren 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 6.1%, 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 Neuren Pharmaceuticals

Strength

• Currently debt free.

Weakness

• No major weaknesses identified for NEU.

Opportunity

• Annual revenue is forecast to grow faster than the Australian market.

• Trading below our estimate of fair value by more than 20%.

Threat

• Annual earnings are forecast to grow slower than the Australian market.

Next Steps:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price sitting below the intrinsic value? For Neuren Pharmaceuticals, we've compiled three fundamental aspects you should look at:

1. Financial Health: Does NEU 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 NEU'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 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!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the ASX every day. If you want to find the calculation for other stocks just search here.

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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.