Stock Analysis

Is There An Opportunity With The Honest Company, Inc.'s (NASDAQ:HNST) 24% Undervaluation?

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NasdaqGS:HNST
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Today we will run through one way of estimating the intrinsic value of The Honest Company, Inc. (NASDAQ:HNST) by estimating the company's future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. 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. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out our latest analysis for Honest Company

The method

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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

2022 2023 2024 2025 2026 2027 2028 2029 2030 2031
Levered FCF ($, Millions) US$10.9m US$26.5m US$40.8m US$50.4m US$57.5m US$63.6m US$68.6m US$72.9m US$76.5m US$79.5m
Growth Rate Estimate Source Analyst x5 Analyst x4 Analyst x1 Analyst x1 Est @ 14.16% Est @ 10.51% Est @ 7.95% Est @ 6.17% Est @ 4.91% Est @ 4.04%
Present Value ($, Millions) Discounted @ 6.6% US$10.2 US$23.3 US$33.7 US$39.0 US$41.8 US$43.3 US$43.9 US$43.7 US$43.0 US$42.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$364m

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 6.6%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$80m× (1 + 2.0%) ÷ (6.6%– 2.0%) = US$1.8b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$1.8b÷ ( 1 + 6.6%)10= US$930m

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$1.3b. 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$10.9, the company appears a touch undervalued at a 24% 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
NasdaqGS:HNST Discounted Cash Flow September 14th 2021

Important 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 Honest Company 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 6.6%, which is based on a levered beta of 0.976. 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. DCF models are not the be-all and end-all of investment valuation. 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 sitting below the intrinsic value? For Honest Company, there are three additional items you should explore:

  1. Risks: For instance, we've identified 1 warning sign for Honest Company that you should be aware of.
  2. Future Earnings: How does HNST'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. 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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