Does the February share price for Life Healthcare Group Holdings Limited (JSE:LHC) reflect what it is really worth? Today we are going to estimate the intrinsic value of the stock by projecting its future cash flows and then discounting them to the present value. We will use the Discounted Cash Flow (DCF) model for this purpose. This may sound complicated, but it’s actually quite simple!

Remember though that there are many ways to estimate the value of a business and a DCF is just one method. If you still have burning questions about this type of assessment, take a look at Simply Wall St.’s analysis template.

Check out our latest analysis for Life Healthcare Group Holdings

What is the estimated valuation?

We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “sustained growth”. In the first step, we need to estimate the company’s cash flow over the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.

Generally, we assume that a dollar today is worth more than a dollar in the future, and so the sum of these future cash flows is then discounted to today’s value:

Estimated free cash flow (FCF) over 10 years

(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = R21b

After calculating the present value of future cash flows over the initial 10-year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 8.9%. We discount the terminal cash flows to their present value at a cost of equity of 16%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = R8.0b × (1 + 8.9%) ÷ (16%–8.9%) = R122b

Present value of terminal value (PVTV)= TV / (1 + r)^ten= R122b÷ ( 1 + 16%)^ten= R28b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is R49b. The final step is to divide the equity value by the number of shares outstanding. Compared to the current share price of R23.6, the company looks slightly undervalued at a 30% discount to the current share price. The assumptions of any calculation have a big impact on the valuation, so it’s best to consider this as a rough estimate, not accurate down to the last penny.

Important assumptions

The above calculation is highly dependent on two assumptions. One is the discount rate and the other is the cash flows. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play around with them. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Life Healthcare Group Holdings 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 takes debt into account. In this calculation, we used 16%, which is based on a leveraged beta of 0.982. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

Next steps:

Although important, the DCF calculation is just one of many factors you need to assess for a business. The DCF model is not a perfect stock valuation tool. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, if the terminal value growth rate is adjusted slightly, it can significantly change the overall result. Can we understand why the company is trading at a discount to its intrinsic value? For Life Healthcare Group Holdings, there are three other aspects you need to consider:

1. Risks: For this purpose, you must know the 1 warning sign we spotted with Life Healthcare Group Holdings.
2. Future earnings: How does the LHC growth rate compare to its peers and the wider market? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
3. Other strong companies: Low debt, high returns on equity and good past performance are essential to a strong business. Why not explore our interactive list of stocks with strong trading fundamentals to see if there are any other companies you may not have considered!

PS. The Simply Wall St app performs a daily updated cash flow assessment for each JSE stock. If you want to find the calculation for other stocks, search here.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.