Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of Rhythm Pharmaceuticals Inc (NASDAQ:RYTM) as an investment opportunity by estimating the company’s future cash flows and discounting them to their present value. This is done using the Discounted Cash Flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. Please also note that this article was written in November 2018 so be sure check out the updated calculation by following the link below.
Is RYTM fairly valued?
I’m 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 perpetual stable growth rate. To start off with we need to estimate the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount the sum of these cash flows to arrive at a present value estimate.
5-year cash flow forecast
|Levered FCF ($, Millions)||$-311.00||$-270.00||$-27.50||$269.50||$312.62|
|Source||Analyst x2||Analyst x2||Analyst x2||Analyst x2||Est @ 16%, capped from 16.56%|
|Present Value Discounted @ 12.43%||$-276.62||$-213.61||$-19.35||$168.68||$174.04|
Present Value of 5-year Cash Flow (PVCF)= -US$166.9m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after the five years. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 2.9%. We discount this to today’s value at a cost of equity of 12.4%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = US$313m × (1 + 2.9%) ÷ (12.4% – 2.9%) = US$3.4b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = US$3.4b ÷ ( 1 + 12.4%)5 = US$1.9b
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is US$1.7b. To get the intrinsic value per share, we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR. This results in an intrinsic value of $50.09. Relative to the current share price of $27.5, the stock is quite good value at a 45% discount to what it is available for right now.
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 my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at Rhythm Pharmaceuticals as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 12.4%, which is based on a levered beta of 1.344. This is derived from the Bottom-Up Beta method based on 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 shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For RYTM, I’ve compiled three relevant aspects you should look at:
- Financial Health: Does RYTM have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does RYTM’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.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of RYTM? 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 for every stock on the NASDAQ every 6 hours. If you want to find the calculation for other stocks just search here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at firstname.lastname@example.org.