Healthcare Services Group, Inc.'s (NASDAQ:HCSG) Intrinsic Value Is Potentially 23% Below Its Share Price

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Healthcare Services Group, Inc. (NASDAQ:HCSG) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. 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. 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 Healthcare Services Group

Step By Step Through The Calculation

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 start off with, we need to estimate 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, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	US$69.7m	US$50.9m	US$41.6m	US$36.6m	US$33.7m	US$32.0m	US$31.1m	US$30.6m	US$30.5m	US$30.6m
Growth Rate Estimate Source	Analyst x3	Est @ -26.88%	Est @ -18.24%	Est @ -12.18%	Est @ -7.95%	Est @ -4.98%	Est @ -2.9%	Est @ -1.45%	Est @ -0.43%	Est @ 0.28%
Present Value ($, Millions) Discounted @ 5.7%	US$65.9	US$45.5	US$35.2	US$29.2	US$25.5	US$22.9	US$21.0	US$19.6	US$18.4	US$17.5

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$300m

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 1.9%. We discount the terminal cash flows to today's value at a cost of equity of 5.7%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$31m× (1 + 1.9%) ÷ (5.7%– 1.9%) = US$818m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$818m÷ ( 1 + 5.7%)¹⁰= US$468m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$768m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of US$13.5, the company appears potentially overvalued at the time of writing. 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.

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 Healthcare Services Group 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 5.7%, which is based on a levered beta of 0.898. 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.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price exceeding the intrinsic value? For Healthcare Services Group, there are three additional items you should look at:

1. Risks: As an example, we've found 2 warning signs for Healthcare Services Group (1 shouldn't be ignored!) that you need to consider before investing here.
2. Future Earnings: How does HCSG'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 NASDAQGS 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.