Stock Analysis

An Intrinsic Calculation For Zimmer Biomet Holdings, Inc. (NYSE:ZBH) Suggests It's 47% Undervalued

  •  Updated
NYSE:ZBH
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Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Zimmer Biomet Holdings, Inc. (NYSE:ZBH) 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. There's really not all that much to it, even though it might appear quite complex.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

See our latest analysis for Zimmer Biomet Holdings

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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Levered FCF ($, Millions) US$1.71b US$1.97b US$2.17b US$2.48b US$2.70b US$2.89b US$3.05b US$3.18b US$3.30b US$3.40b
Growth Rate Estimate Source Analyst x4 Analyst x4 Analyst x3 Analyst x2 Est @ 9.04% Est @ 6.93% Est @ 5.44% Est @ 4.41% Est @ 3.68% Est @ 3.18%
Present Value ($, Millions) Discounted @ 6.7% US$1.6k US$1.7k US$1.8k US$1.9k US$2.0k US$2.0k US$1.9k US$1.9k US$1.8k US$1.8k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$18b

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 6.7%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$3.4b× (1 + 2.0%) ÷ (6.7%– 2.0%) = US$74b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$74b÷ ( 1 + 6.7%)10= US$39b

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$57b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$146, the company appears quite good value at a 47% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

dcf
NYSE:ZBH Discounted Cash Flow September 17th 2021

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Zimmer Biomet Holdings 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 6.7%, which is based on a levered beta of 0.991. 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.

Next Steps:

Whilst important, the DCF calculation 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. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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. Can we work out why the company is trading at a discount to intrinsic value? For Zimmer Biomet Holdings, we've put together three essential aspects you should consider:

  1. Risks: Every company has them, and we've spotted 2 warning signs for Zimmer Biomet Holdings (of which 1 is a bit unpleasant!) you should know about.
  2. Future Earnings: How does ZBH'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 American stock every day, so if you want to find the intrinsic value of any other stock just search here.

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