The a2 Milk Company Limited (ASX:A2M) Investors Are Paying Above The Intrinsic Value

I am going to run you through how I calculated the intrinsic value of The a2 Milk Company Limited (ASX:A2M) by estimating the company's future cash flows and discounting them to their present value. This is done using the discounted cash flows (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward. 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 May 2018 then I highly recommend you check out the latest calculation for a2 Milk by following the link below. See our latest analysis for a2 Milk

What's the value?

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 begin with we have to get estimates of the next five years of cash flows. Where possible I use analyst 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 five years, but capped at a reasonable level. I then discount the sum of these cash flows to arrive at a present value estimate.

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 an annual growth rate equal to the 10-year government bond rate of 2.8%. We discount this to today's value at a cost of equity of 8.6%.

The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is A$6,094. To get the intrinsic value per share, we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR. This results in an intrinsic value of A$7.61, which, compared to the current share price of A$9.93, we find that a2 Milk is quite expensive and not available at a discount at this time.

Important assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 a2 Milk as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I've used 8.6%, which is based on a levered beta of 0.8. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For A2M, I've compiled three important aspects you should further research:

1. Financial Health: Does A2M 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.
2. Future Earnings: How does A2M'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.
3. Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of A2M? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

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.

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Simply Wall St analyst Simply Wall St and Simply Wall St have no position in any of the companies mentioned. This article is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.