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Is There An Opportunity With Chemed Corporation's (NYSE:CHE) 34% Undervaluation?

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How far off is Chemed Corporation (NYSE:CHE) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by estimating the company's future cash flows and discounting them to their present value. I will use the Discounted Cash Flow (DCF) model. 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. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

Step by step through 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 start off with, we need to estimate the next ten years of cash flows. 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

 2019 2020 2021 2022 2023 2024 2025 2026 2027 2028 Levered FCF (\$, Millions) \$287.99 \$331.57 \$369.40 \$401.93 \$429.99 \$454.54 \$476.42 \$496.37 \$514.99 \$532.73 Growth Rate Estimate Source Est @ 20.44% Est @ 15.13% Est @ 11.41% Est @ 8.81% Est @ 6.98% Est @ 5.71% Est @ 4.81% Est @ 4.19% Est @ 3.75% Est @ 3.44% Present Value (\$, Millions) Discounted @ 7.5% \$267.90 \$286.93 \$297.37 \$300.99 \$299.54 \$294.55 \$287.20 \$278.36 \$268.66 \$258.53

Present Value of 10-year Cash Flow (PVCF)= \$2.84b

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

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 7.5%.

Terminal Value (TV) = FCF2029 Ã— (1 + g) Ã· (r â€“ g) = US\$533m Ã— (1 + 2.7%) Ã· (7.5% â€“ 2.7%) = US\$11b

Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = \$US\$11b Ã· ( 1 + 7.5%)10 = \$5.57b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is \$8.41b. The last step is to then divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate of \$527.61. Relative to the current share price of \$347.97, the company appears quite good value at a 34% discount to where the stock price trades currently. 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.

Important assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Chemed 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 7.5%, 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.

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 Chemed, There are three fundamental factors you should look at:

1. Financial Health: Does CHE 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 CHE'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 CHE? 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 NYSE 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.