Today we’ll walk through one way to estimate the intrinsic value of Cochlear Limited (ASX:COH) by projecting its future cash flows and then discounting them to present value. We will use the Discounted Cash Flow (DCF) model for this purpose. Before you think you can’t figure it out, just read on! It’s actually a lot less complex than you might imagine.

Remember though that there are many ways to estimate the value of a business and a DCF is just one method. For those who are passionate about stock analysis, the Simply Wall St analysis template here may interest you.

See our latest review for Cochlear

The model

We use what is called a 2-stage model, which simply means that we have two different periods of company cash flow growth rates. Generally, the first stage is a higher growth phase and the second stage is a lower growth phase. To begin with, we need to obtain cash flow estimates for 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) = AU$3.3 billion

We now need to calculate the terminal value, which represents all future cash flows after this ten-year period. For a number of reasons, a very conservative growth rate is used which cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (1.9%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 5.9%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = AU$661 million × (1 + 1.9%) ÷ (5.9%–1.9%) = AU$17 billion

Present value of terminal value (PVTV)= TV / (1 + r)^ten= AU$17 billion÷ ( 1 + 5.9%)^ten= 9.5 billion Australian dollars

The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is A$13 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of AU$195, the company appears to be approximately fair value at a 0.5% discount to the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in a different galaxy. Keep that in mind.

Important assumptions

We emphasize that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. If you disagree with these results, try the math yourself and play around with the assumptions. 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. As we view Cochlear 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 5.9%, which is based on a leveraged beta of 0.912. 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.

Let’s move on :

Although the valuation of a business is important, it will ideally not be the only piece of analysis you will look at for a business. DCF models are not the be-all and end-all of investment valuation. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. If a company grows at a different pace, or if its cost of equity or risk-free rate changes sharply, output may be very different. For Cochlear, we have compiled three relevant items that you should consider:

1. Financial health: Does the COH have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors such as leverage and risk.
2. Future earnings: How does COH’s growth rate compare to its peers and the market in general? 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 discounted cash flow valuation for every stock on the ASX every day. 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.