Are Investors Undervaluing HLS Therapeutics Inc. (TSE:HLS) By 45%?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, HLS Therapeutics fair value estimate is CA$6.42
• Current share price of CA$3.51 suggests HLS Therapeutics is potentially 45% undervalued
• Analyst price target for HLS is US$6.08 which is 5.3% below our fair value estimate

Today we will run through one way of estimating the intrinsic value of HLS Therapeutics Inc. (TSE:HLS) by taking the expected future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

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.

Check out our latest analysis for HLS Therapeutics

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. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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, 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

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF ($, Millions)	US$7.45m	US$6.67m	US$6.23m	US$5.98m	US$5.85m	US$5.80m	US$5.80m	US$5.84m	US$5.91m	US$5.99m
Growth Rate Estimate Source	Est @ -15.87%	Est @ -10.45%	Est @ -6.66%	Est @ -4.01%	Est @ -2.15%	Est @ -0.85%	Est @ 0.06%	Est @ 0.69%	Est @ 1.14%	Est @ 1.45%
Present Value ($, Millions) Discounted @ 5.7%	US$7.1	US$6.0	US$5.3	US$4.8	US$4.4	US$4.2	US$3.9	US$3.8	US$3.6	US$3.4

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$46m

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 5.7%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = US$6.0m× (1 + 2.2%) ÷ (5.7%– 2.2%) = US$175m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$175m÷ ( 1 + 5.7%)¹⁰= US$101m

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$147m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of CA$3.5, the company appears quite undervalued at a 45% 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

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 these inputs, I recommend redoing the calculations yourself and playing with them. 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 HLS Therapeutics 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 5.7%, which is based on a levered beta of 0.850. 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.

Moving On:

Although the valuation of a company is important, 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. 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. What is the reason for the share price sitting below the intrinsic value? For HLS Therapeutics, we've put together three important factors you should further examine:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with HLS Therapeutics , and understanding these should be part of your investment process.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for HLS'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the TSX 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.