Are Investors Undervaluing Carl Zeiss Meditec AG (ETR:AFX) By 39%?

Key Insights

• Carl Zeiss Meditec's estimated fair value is €96.42 based on 2 Stage Free Cash Flow to Equity
• Carl Zeiss Meditec is estimated to be 39% undervalued based on current share price of €58.85
• The €60.53 analyst price target for AFX is 37% less than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of Carl Zeiss Meditec AG (ETR:AFX) by taking the expected future cash flows and discounting them to their present value. Our analysis will employ the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

We've discovered 2 warning signs about Carl Zeiss Meditec. View them for free.

Is Carl Zeiss Meditec Fairly Valued?

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. 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.

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

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF (€, Millions)	€151.5m	€205.1m	€236.4m	€308.0m	€347.4m	€375.5m	€397.9m	€415.9m	€430.4m	€442.3m
Growth Rate Estimate Source	Analyst x7	Analyst x7	Analyst x5	Analyst x1	Analyst x1	Est @ 8.07%	Est @ 5.98%	Est @ 4.51%	Est @ 3.49%	Est @ 2.77%
Present Value (€, Millions) Discounted @ 5.4%	€144	€185	€202	€249	€267	€273	€275	€272	€267	€260

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = €2.4b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (1.1%) 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 5.4%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = €442m× (1 + 1.1%) ÷ (5.4%– 1.1%) = €10b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= €10b÷ ( 1 + 5.4%)¹⁰= €6.0b

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 €8.4b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of €58.9, the company appears quite good value at a 39% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 Carl Zeiss Meditec 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 5.4%, which is based on a levered beta of 1.005. 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.

See our latest analysis for Carl Zeiss Meditec

SWOT Analysis for Carl Zeiss Meditec

Looking Ahead:

Although the valuation of a company is important, it is only one of many factors that you need to assess for 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. What is the reason for the share price sitting below the intrinsic value? For Carl Zeiss Meditec, we've compiled three pertinent aspects you should consider:

1. Risks: For example, we've discovered 2 warning signs for Carl Zeiss Meditec that you should be aware of before investing here.
2. Future Earnings: How does AFX'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. Simply Wall St updates its DCF calculation for every German 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.