CSL Limited (ASX:CSL) Shares Could Be 24% Below Their Intrinsic Value Estimate

In this article we are going to estimate the intrinsic value of CSL Limited (ASX:CSL) by taking the expected future cash flows and discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

See our latest analysis for CSL

Step By Step Through The Calculation

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. In the first stage we need to estimate the cash flows to the business over the next ten years. 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) forecast

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	US$1.57b	US$2.32b	US$3.05b	US$3.63b	US$4.23b	US$4.67b	US$5.04b	US$5.34b	US$5.60b	US$5.82b
Growth Rate Estimate Source	Analyst x6	Analyst x6	Analyst x5	Analyst x2	Analyst x2	Est @ 10.37%	Est @ 7.82%	Est @ 6.04%	Est @ 4.79%	Est @ 3.91%
Present Value ($, Millions) Discounted @ 5.9%	US$1.5k	US$2.1k	US$2.6k	US$2.9k	US$3.2k	US$3.3k	US$3.4k	US$3.4k	US$3.3k	US$3.3k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$29b

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 a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.9%. We discount the terminal cash flows to today's value at a cost of equity of 5.9%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$5.8b× (1 + 1.9%) ÷ (5.9%– 1.9%) = US$146b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$146b÷ ( 1 + 5.9%)¹⁰= US$82b

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$111b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of AU$275, the company appears a touch undervalued at a 24% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 CSL 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 5.9%, which is based on a levered beta of 0.865. 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.

Next Steps:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For CSL, there are three further items you should consider:

1. Risks: Every company has them, and we've spotted 2 warning signs for CSL you should know about.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for CSL's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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. Simply Wall St updates its DCF calculation for every Australian 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. 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.