I am going to run you through how I calculated the intrinsic value of Bellamy’s Australia (ASX:BAL) using a method called discounted cash flow or DCF. Discounted cash flow (DCF) is a valuation method used to estimate the attractiveness of an investment opportunity by taking the expected Future Cash Flows and discounting them to their present valye. It sounds complicated, but actually it is quite simple!

If you want to learn more about discounted cash flow, the basis for my calcs can be read in detail in the Simply Wall St analysis model.If you are reading this and its not April 2017 then I highly recommend you check out the latest calculation for Bellamy’s Australia by following the link below. See our latest analysis for BAL

I use what is known as a 2-stage model, which simply means we have two different periods where we need to estimate cash flows. In the 1st stage we need to estimate the cash flows to the business over the next 5 years, where possible I use analysts estimates but when these aren’t available I have extrapolated the previous Free Cash Flow (FCF) from the year before. For this growth rate I used the average annual growth rate over the past 5 years, but capped to a reasonable level. I then discount the sum of these cash flows to arrive at a present value estimate.

### Step by step through the calculation

Please note that the numbers here are in millions apart from the per share values.

#### 5-year cash flow forecast

2017 | 2018 | 2019 | 2020 | 2021 | |

Levered FCF (AUD, Millions) | $-27.12 | $22.93 | $25.67 | $32.12 | $37.26 |

Source | Analyst x3 | Analyst x3 | Analyst x2 | Analyst x1 | Extrapolated @ (16%, capped from 38.57%) |

Present Value Discounted @ 8.55% | $-24.98 | $19.46 | $20.07 | $23.13 | $24.72 |

Present value of next 5 years cash flows: $62

After calculating the present value of cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the 1st stage. The Perpetuity Method (Gordon Formula) is used to calculate Terminal Value at an annual growth rate equal to the 10 year government bond rate of (2.8%).

#### Terminal Value

Terminal Value = FCF_{2021} × (1 + g) ÷ (Discount Rate – g)

Terminal Value = $37 × (1 + 2.8%) ÷ (8.6% – 2.8%)

Terminal value based on the Perpetuity Method where growth (g) = 2.8%: $661

**Present value of terminal value: $439**

So the total value is the sum of the next 5 years cash flows and the terminal value discounted to today, this is known as the Equity Value.

#### Equity Value

Equity Value (Total value) = Present value of next 5 years cash flows + terminal value = $62 + $439 = $501

In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number.

Value = Total value / Shares Outstanding ($500.93 / 96.69)

**Value per share: $5.18**

To finish off with if we compare the intrinsic value of 5.18 to the current share price of $4.45 we find Bellamy’s Australia (ASX:BAL) is a touch undervalued at a **14% discount to what it is available for right now**.

### The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. You don’t have to agree with my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at Bellamy’s Australia as potential investors the Cost of Equity is used as the discount rate, not the Cost of Capital (or Weighed Average Cost of Capital/ WACC) which accounts for debt.

In this calculation I’ve used 8.6% and this is based on a Levered Beta of 0.8. I’m not going to go into how I calculate the Levered Beta in detail, I used the ‘Bottom up Beta’ method based on the comparable businesses, I also impose a limit between 0.8 and 2 which is a reasonable range for a stable business. Google this if you want to learn more.

### Conclusion

Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. Is Bellamy’s Australia in a healthy financial condition? What is the reason for the share price to differ from the intrinsic value?** See our latest FREE analysis to find out!**

PS. Simply Wall St does a DCF calculation for every AU stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.