What’s the value?
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 begin with we have to get estimates of 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 this to its value today and sum up the total to get the present value of these cash flows.
5-year cash flow estimate
| 2018 | 2019 | 2020 | 2021 | 2022 | |
| Levered FCF ($, Millions) | $-87.92 | $-54.92 | $-15.61 | $25.62 | $81.34 |
| Source | Analyst x1 | Analyst x1 | Analyst x1 | Analyst x1 | Analyst x1 |
| Present Value Discounted @ 10.95% | $-79.25 | $-44.62 | $-11.43 | $16.91 | $48.39 |
Present Value of 5-year Cash Flow (PVCF)= $-70
After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 2.5%. We discount this to today’s value at a cost of equity of 10.9%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = $81 × (1 + 2.5%) ÷ (10.9% – 2.5%) = $983
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = $983 / ( 1 + 10.9%)5 = $585
The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is $515. In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number. This results in an intrinsic value of $9.10, which, compared to the current share price of $5.24, we see that Verastem is quite good value at a 42.40% discount to what it is available for right now.
Important assumptions
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. If you don’t agree with my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Verastem 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 10.9%, which is based on a levered beta of 1.126. 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.
Next Steps:
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 VSTM, I’ve compiled three essential aspects you should further examine:
- Financial Health: Does VSTM 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 VSTM’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 VSTM? 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 does a DCF calculation for every US stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.