Faron Pharmaceuticals Oy's (LON:FARN) Intrinsic Value Is Potentially 74% Above Its Share Price

Key Insights

• Faron Pharmaceuticals Oy's estimated fair value is UK£4.95 based on 2 Stage Free Cash Flow to Equity
• Faron Pharmaceuticals Oy's UK£2.85 share price signals that it might be 42% undervalued
• Analyst price target for FARN is €4.01 which is 19% below our fair value estimate

Does the August share price for Faron Pharmaceuticals Oy (LON:FARN) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the forecast future cash flows of the company and discounting them back to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. It may sound complicated, but actually it is quite simple!

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

View our latest analysis for Faron Pharmaceuticals Oy

Is Faron Pharmaceuticals Oy Fairly Valued?

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (€, Millions)	€18.6m	€1.90m	€7.70m	€20.1m	€21.4m	€22.4m	€23.3m	€24.0m	€24.6m	€25.1m
Growth Rate Estimate Source	Analyst x2	Analyst x1	Analyst x1	Analyst x1	Est @ 6.44%	Est @ 4.88%	Est @ 3.79%	Est @ 3.02%	Est @ 2.49%	Est @ 2.11%
Present Value (€, Millions) Discounted @ 6.6%	€17.4	€1.7	€6.4	€15.6	€15.6	€15.3	€14.9	€14.4	€13.9	€13.3

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = €128m

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 (1.2%) 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 6.6%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = €25m× (1 + 1.2%) ÷ (6.6%– 1.2%) = €477m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= €477m÷ ( 1 + 6.6%)¹⁰= €252m

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 €381m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of UK£2.9, the company appears quite good value at a 42% 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.

Important Assumptions

We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Faron Pharmaceuticals Oy 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 6.6%, which is based on a levered beta of 0.805. 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.

SWOT Analysis for Faron Pharmaceuticals Oy

Looking Ahead:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching 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. 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. Can we work out why the company is trading at a discount to intrinsic value? For Faron Pharmaceuticals Oy, we've put together three relevant factors you should further examine:

1. Risks: Case in point, we've spotted 4 warning signs for Faron Pharmaceuticals Oy you should be aware of, and 2 of them don't sit too well with us.
2. Future Earnings: How does FARN'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the AIM 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.