Is There An Opportunity With Oceania Healthcare Limited's (NZSE:OCA) 32% Undervaluation?

In this article we are going to estimate the intrinsic value of Oceania Healthcare Limited (NZSE:OCA) by estimating the company's future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Oceania Healthcare

What's the estimated valuation?

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. In the first stage we need to estimate the cash flows to the business over the next ten years. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

	2021	2022	2023	2024	2025	2026	2027	2028	2029	2030
Levered FCF (NZ$, Millions)	NZ$54.8m	NZ$60.0m	NZ$64.4m	NZ$68.3m	NZ$71.7m	NZ$74.7m	NZ$77.5m	NZ$80.2m	NZ$82.7m	NZ$85.2m
Growth Rate Estimate Source	Est @ 12.41%	Est @ 9.47%	Est @ 7.41%	Est @ 5.96%	Est @ 4.96%	Est @ 4.25%	Est @ 3.75%	Est @ 3.41%	Est @ 3.17%	Est @ 3%
Present Value (NZ$, Millions) Discounted @ 8.1%	NZ$50.7	NZ$51.4	NZ$51.1	NZ$50.1	NZ$48.7	NZ$46.9	NZ$45.1	NZ$43.1	NZ$41.2	NZ$39.3

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NZ$467m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.6%. We discount the terminal cash flows to today's value at a cost of equity of 8.1%.

Terminal Value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = NZ$85m× (1 + 2.6%) ÷ (8.1%– 2.6%) = NZ$1.6b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= NZ$1.6b÷ ( 1 + 8.1%)¹⁰= NZ$739m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is NZ$1.2b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of NZ$1.3, the company appears quite good value at a 32% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Oceania Healthcare 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 8.1%, which is based on a levered beta of 0.907. 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.

Looking Ahead:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize 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 example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Oceania Healthcare, we've compiled three additional factors you should assess:

1. Risks: For example, we've discovered 3 warning signs for Oceania Healthcare that you should be aware of before investing here.
2. Future Earnings: How does OCA'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 Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!

PS. Simply Wall St updates its DCF calculation for every New Zealander 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. 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.
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