Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of Hikma Pharmaceuticals PLC (LON:HIK) as an investment opportunity by estimating the company’s future cash flows and discounting them to their present value. I will be using the discounted cash flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. 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. If you are reading this and its not December 2018 then I highly recommend you check out the latest calculation for Hikma Pharmaceuticals by following the link below.
What’s the value?
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 the sum of these cash flows to arrive at a present value estimate.
5-year cash flow forecast
|Levered FCF ($, Millions)||$276.02||$330.10||$362.96||$399.09||$438.81|
|Source||Analyst x6||Analyst x2||Est @ 9.95%||Est @ 9.95%||Est @ 9.95%|
|Present Value Discounted @ 8.28%||$254.91||$281.55||$285.90||$290.33||$294.82|
Present Value of 5-year Cash Flow (PVCF)= US$1.4b
After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 1.4%. We discount this to today’s value at a cost of equity of 8.3%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = US$439m × (1 + 1.4%) ÷ (8.3% – 1.4%) = US$6.5b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = US$6.5b ÷ ( 1 + 8.3%)5 = US$4.3b
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is US$5.8b. The last step is to then 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) then we use the equivalent number. This results in an intrinsic value of £18.85. Compared to the current share price of £18.92, the stock is fair value, maybe slightly overvalued and not available at a discount at this time.
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 my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at Hikma Pharmaceuticals 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 8.3%, 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.
Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. For HIK, there are three key aspects you should look at:
- Financial Health: Does HIK 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 HIK’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 HIK? 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 for every stock on the LON every 6 hours. If you want to find the calculation for other stocks 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 email@example.com.