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In this article we are going to estimate the intrinsic value of Novartis AG (VTX:NOVN) by taking the foreast future cash flows of the company and discounting them back to today’s value. I will be using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
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. 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.
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 are 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, and so the sum of these future cash flows is then discounted to today’s value:
10-year free cash flow (FCF) forecast
|Levered FCF ($, Millions)||$10.39k||$11.93k||$11.52k||$11.35k||$11.35k||$11.45k||$11.64k||$11.89k||$12.19k||$12.52k|
|Growth Rate Estimate Source||Analyst x7||Analyst x10||Analyst x5||Est @ -1.47%||Est @ -0.05%||Est @ 0.95%||Est @ 1.65%||Est @ 2.13%||Est @ 2.48%||Est @ 2.72%|
|Present Value ($, Millions) Discounted @ 8.42%||$9.58k||$10.15k||$9.04k||$8.22k||$7.58k||$7.05k||$6.61k||$6.23k||$5.89k||$5.58k|
Present Value of 10-year Cash Flow (PVCF)= $75.93b
“Est” = FCF growth rate estimated by Simply Wall St
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 10-year government bond rate (3.3%) 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 8.4%.
Terminal Value (TV) = FCF2029 × (1 + g) ÷ (r – g) = US$13b × (1 + 3.3%) ÷ (8.4% – 3.3%) = US$251b
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = $US$251b ÷ ( 1 + 8.4%)10 = $112.08b
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 $188.01b. In the final step we divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate in the company’s reported currency of $80.94. However, NOVN’s primary listing is in Switzerland, and 1 share of NOVN in USD represents 1.011 ( USD/ CHF) share of NYSE:NVS, so the intrinsic value per share in CHF is CHF81.85. Relative to the current share price of CHF82.14, the company appears around fair value at the time of writing. 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 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 Novartis 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 8.4%, which is based on a levered beta of 0.863. 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.
Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching 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?” If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For Novartis, I’ve put together three important aspects you should further research:
- Financial Health: Does NOVN 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.
- Future Earnings: How does NOVN’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 High Quality Alternatives: Are there other high quality stocks you could be holding instead of NOVN? 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 VTX every day. If you want to find the calculation for other stocks just search here.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.