Investors Are Undervaluing Novartis AG (VTX:NOVN) By 38.33%

Does the January share price for Novartis AG (VTX:NOVN) reflect it’s really worth? Today, I will calculate the stock’s intrinsic value by taking the foreast future cash flows of the company and discounting them back to today’s value. This is done using the Discounted Cash Flows (DCF) model. It may sound complicated, but actually it is quite simple! 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. Please also note that this article was written in January 2019 so be sure check out the updated calculation by following the link below.

Check out our latest analysis for Novartis

The calculation

I use what is known as a 2-stage model, which simply means we have two different periods of varying growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a more stable growth phase. To start off with we need to estimate the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount this to its value today and sum up the total to get the present value of these cash flows.

5-year cash flow estimate

2019 2020 2021 2022 2023
Levered FCF ($, Millions) $12.68k $13.72k $15.28k $19.64k $21.14k
Source Analyst x12 Analyst x10 Analyst x2 Analyst x1 Analyst x1
Present Value Discounted @ 8.66% $11.67k $11.62k $11.91k $14.09k $13.96k

Present Value of 5-year Cash Flow (PVCF)= US$63b

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 the GDP. In this case I have used the 10-year government bond rate (3.3%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 8.7%.

Terminal Value (TV) = FCF2023 × (1 + g) ÷ (r – g) = US$21b × (1 + 3.3%) ÷ (8.7% – 3.3%) = US$406b

Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = US$406b ÷ ( 1 + 8.7%)5 = US$268b

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 US$331b. In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number. This results in an intrinsic value of CHF142.73. Compared to the current share price of CHF88.02, the stock is quite good value at a 38% discount to what it is available for right now.

SWX:NOVN Intrinsic Value Export January 25th 19
SWX:NOVN Intrinsic Value Export January 25th 19

Important assumptions

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 my result, have a go at the calculation yourself and play with the assumptions. Because 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 weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 8.7%, which is based on a levered beta of 0.800. 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:

Whilst important, DCF calculation 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 NOVN, I’ve compiled three important factors you should further research:

  1. 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.
  2. 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.
  3. 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. Simply Wall St does a DCF calculation for every CH stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.

To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.

The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.