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Are Investors Undervaluing Sage Therapeutics, Inc. (NASDAQ:SAGE) By 29%?

How far off is Sage Therapeutics, Inc. (NASDAQ:SAGE) 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 foreast future cash flows of the company and discounting them back to today's value. This is done using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

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Is Sage Therapeutics fairly valued?

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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 Levered FCF (\$, Millions) \$-489.25 \$-481.10 \$-459.30 \$-251.95 \$530.53 \$814.62 \$1.13k \$1.44k \$1.73k \$1.99k Growth Rate Estimate Source Analyst x4 Analyst x4 Analyst x3 Analyst x2 Analyst x3 Est @ 53.55% Est @ 38.3% Est @ 27.63% Est @ 20.16% Est @ 14.93% Present Value (\$, Millions) Discounted @ 10.23% \$-443.84 \$-395.94 \$-342.91 \$-170.65 \$325.98 \$454.07 \$569.70 \$659.62 \$719.03 \$749.69

Present Value of 10-year Cash Flow (PVCF)= \$2.12b

"Est" = FCF growth rate estimated by Simply Wall St

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 10-year government bond rate (2.7%) 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 10.2%.

Terminal Value (TV) = FCF2029 Ã— (1 + g) Ã· (r â€“ g) = US\$2.0b Ã— (1 + 2.7%) Ã· (10.2% â€“ 2.7%) = US\$27b

Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = \$US\$27b Ã· ( 1 + 10.2%)10 = \$10.27b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is \$12.39b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. This results in an intrinsic value estimate of \$242.27. Relative to the current share price of \$171.03, the company appears a touch undervalued at a 29% 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.

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. 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 Sage Therapeutics 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 10.2%, which is based on a levered beta of 1.259. 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.

Next Steps:

Although the valuation of a company is important, it shouldnâ€™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. What is the reason for the share price to differ from the intrinsic value? For Sage Therapeutics, There are three further aspects you should further research:

1. Financial Health: Does SAGE 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 SAGE'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 SAGE? 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 NASDAQ every day. If you want to find the calculation for other stocks just search here.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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.