Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Scholar Rock Holding Corporation (NASDAQ:SRRK) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. I will be using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
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.
What's the estimated valuation?
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.
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
|Levered FCF ($, Millions)||$15.6m||$19.4m||$22.9m||$26.0m||$28.7m||$31.0m||$32.9m||$34.7m||$36.3m||$37.7m|
|Growth Rate Estimate Source||Est @ 34.02%||Est @ 24.63%||Est @ 18.06%||Est @ 13.46%||Est @ 10.24%||Est @ 7.99%||Est @ 6.41%||Est @ 5.31%||Est @ 4.53%||Est @ 3.99%|
|Present Value ($, Millions) Discounted @ 10.04%||$14.2||$16.0||$17.2||$17.7||$17.8||$17.4||$16.9||$16.1||$15.3||$14.5|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF)= $163.0m
The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 2.7%. We discount the terminal cash flows to today's value at a cost of equity of 10%.
Terminal Value (TV) = FCF2029 × (1 + g) ÷ (r – g) = US$38m × (1 + 2.7%) ÷ (10% – 2.7%) = US$530m
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = $US$530m ÷ ( 1 + 10%)10 = $203.63m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is $366.63m. 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 $12.35. Compared to the current share price of $9.71, the company appears a touch undervalued at a 21% 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.
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 Scholar Rock Holding 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%, which is based on a levered beta of 1.226. 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, DCF calculation 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. What is the reason for the share price to differ from the intrinsic value? For Scholar Rock Holding, I've compiled three important aspects you should further examine:
- Financial Health: Does SRRK 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 SRRK'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 SRRK? 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.
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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.