Stock Analysis

Is There An Opportunity With Cardinal Health, Inc.'s (NYSE:CAH) 44% Undervaluation?

NYSE:CAH
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Today we will run through one way of estimating the intrinsic value of Cardinal Health, Inc. (NYSE:CAH) by estimating the company's future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

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 Cardinal Health

Crunching The Numbers

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$1.74b US$1.92b US$1.78b US$1.91b US$1.94b US$1.96b US$1.99b US$2.03b US$2.06b US$2.10b
Growth Rate Estimate Source Analyst x6 Analyst x6 Analyst x4 Analyst x2 Analyst x2 Est @ 1.28% Est @ 1.49% Est @ 1.64% Est @ 1.74% Est @ 1.81%
Present Value ($, Millions) Discounted @ 6.8% US$1.6k US$1.7k US$1.5k US$1.5k US$1.4k US$1.3k US$1.3k US$1.2k US$1.1k US$1.1k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$14b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 (2.0%) 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 6.8%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$2.1b× (1 + 2.0%) ÷ (6.8%– 2.0%) = US$44b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$44b÷ ( 1 + 6.8%)10= US$23b

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$37b. 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$78.3, the company appears quite good value at a 44% 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.

dcf
NYSE:CAH Discounted Cash Flow December 14th 2022

Important Assumptions

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 Cardinal Health 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 6.8%, which is based on a levered beta of 0.867. 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:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. 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. What is the reason for the share price sitting below the intrinsic value? For Cardinal Health, we've put together three relevant items you should consider:

  1. Risks: Every company has them, and we've spotted 4 warning signs for Cardinal Health you should know about.
  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for CAH's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
  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 NYSE every day. If you want to find the calculation for other stocks just search here.

Valuation is complex, but we're helping make it simple.

Find out whether Cardinal Health is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.

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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.