Today we will run through one way of estimating the intrinsic value of Eli Lilly and Company (NYSE:LLY) by taking the forecast future cash flows of the company and discounting them back to today’s value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Don’t get put off by the jargon, the math behind it is actually quite straightforward.
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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
What’s the estimated valuation?
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren’t available we extrapolate the previous free cash flow (FCF) from the last estimate or 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 discount the value of these future cash flows to their estimated value in today’s dollars:
10-year free cash flow (FCF) estimate
|Levered FCF ($, Millions)||US$6.46b||US$7.44b||US$7.85b||US$8.69b||US$9.32b||US$9.85b||US$10.3b||US$10.7b||US$11.1b||US$11.4b|
|Growth Rate Estimate Source||Analyst x5||Analyst x3||Analyst x2||Analyst x2||Est @ 7.2%||Est @ 5.7%||Est @ 4.66%||Est @ 3.93%||Est @ 3.41%||Est @ 3.06%|
|Present Value ($, Millions) Discounted @ 7.0%||US$6.0k||US$6.5k||US$6.4k||US$6.6k||US$6.6k||US$6.5k||US$6.4k||US$6.2k||US$6.0k||US$5.8k|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$63b
The second stage is also known as Terminal Value, this is the business’s cash flow after the first stage. 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 5-year average of the 10-year government bond yield (2.2%) 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 7.0%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$11b× (1 + 2.2%) ÷ (7.0%– 2.2%) = US$242b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$242b÷ ( 1 + 7.0%)10= US$123b
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$186b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of US$148, the company appears a touch undervalued at a 28% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula – garbage in, garbage out.
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 Eli Lilly 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 7.0%, which is based on a levered beta of 0.802. 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.
Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for 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?” For example, changes in the company’s cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Eli Lilly, we’ve compiled three essential items you should explore:
- Risks: For example, we’ve discovered 1 warning sign for Eli Lilly that you should be aware of before investing here.
- Future Earnings: How does LLY’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 Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!
PS. Simply Wall St updates its DCF calculation for every American stock every day, so if you want to find the intrinsic value of any other stock just search here.
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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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