Today we'll do a simple run through of a valuation method used to estimate the attractiveness of ShockWave Medical, Inc. (NASDAQ:SWAV) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back to today's value. This will be done using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
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 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. 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, 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) estimate
|Levered FCF ($, Millions)||US$50.8m||US$115.4m||US$164.4m||US$221.2m||US$264.5m||US$302.3m||US$334.3m||US$361.1m||US$383.5m||US$402.5m|
|Growth Rate Estimate Source||Analyst x1||Analyst x1||Analyst x1||Analyst x1||Est @ 19.56%||Est @ 14.29%||Est @ 10.6%||Est @ 8.02%||Est @ 6.21%||Est @ 4.94%|
|Present Value ($, Millions) Discounted @ 6.2%||US$47.8||US$102||US$137||US$174||US$196||US$211||US$220||US$224||US$224||US$221|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$1.8b
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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 6.2%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$402m× (1 + 2.0%) ÷ (6.2%– 2.0%) = US$9.8b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$9.8b÷ ( 1 + 6.2%)10= US$5.4b
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 US$7.2b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of US$223, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
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 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 ShockWave Medical 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 6.2%, which is based on a levered beta of 0.885. 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.
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?" 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. For ShockWave Medical, we've compiled three important elements you should look at:
- Risks: For example, we've discovered 3 warning signs for ShockWave Medical that you should be aware of before investing here.
- Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for SWAV's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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 American stock every day, so if you want to find the intrinsic value of any other stock just search here.
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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
When trading ShockWave Medical or any other investment, use the platform considered by many to be the Professional's Gateway to the Worlds Market, Interactive Brokers. You get the lowest-cost* trading on stocks, options, futures, forex, bonds and funds worldwide from a single integrated account.Promoted