Is There An Opportunity With Sigma Healthcare Limited's (ASX:SIG) 49% Undervaluation?

Key Insights

• Sigma Healthcare's estimated fair value is AU$1.79 based on 2 Stage Free Cash Flow to Equity
• Current share price of AU$0.91 suggests Sigma Healthcare is potentially 49% undervalued
• Analyst price target for SIG is AU$0.85 which is 52% below our fair value estimate

Today we will run through one way of estimating the intrinsic value of Sigma Healthcare Limited (ASX:SIG) by projecting its future cash flows and then discounting them 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 would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for Sigma Healthcare

Step By Step Through The Calculation

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 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	AU$10.8m	-AU$11.0m	AU$93.0m	AU$65.0m	AU$80.0m	AU$91.2m	AU$100.6m	AU$108.6m	AU$115.3m	AU$121.0m
Growth Rate Estimate Source	Analyst x3	Analyst x2	Analyst x1	Analyst x1	Analyst x1	Est @ 13.96%	Est @ 10.39%	Est @ 7.90%	Est @ 6.15%	Est @ 4.93%
Present Value (A$, Millions) Discounted @ 6.1%	AU$10.1	-AU$9.8	AU$77.9	AU$51.3	AU$59.6	AU$64.0	AU$66.6	AU$67.7	AU$67.8	AU$67.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$522m

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 (2.1%) 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 6.1%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$121m× (1 + 2.1%) ÷ (6.1%– 2.1%) = AU$3.1b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$3.1b÷ ( 1 + 6.1%)¹⁰= AU$1.7b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$2.2b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of AU$0.9, the company appears quite good value at a 49% 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.

Important Assumptions

We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Sigma Healthcare 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 6.1%, which is based on a levered beta of 0.800. 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.

SWOT Analysis for Sigma Healthcare

Looking Ahead:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Why is the intrinsic value higher than the current share price? For Sigma Healthcare, there are three essential aspects you should further examine:

1. Risks: We feel that you should assess the 2 warning signs for Sigma Healthcare we've flagged before making an investment in the company.
2. Future Earnings: How does SIG'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: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the ASX every day. If you want to find the calculation for other stocks just search here.

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This article by Simply Wall St 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. Simply Wall St has no position in any stocks mentioned.