Are Investors Undervaluing Wave Life Sciences Ltd. (NASDAQ:WVE) By 47%?

Key Insights

• Wave Life Sciences' estimated fair value is US$8.4 based on 2 Stage Free Cash Flow to Equity
• Current share price of US$4.5 suggests Wave Life Sciences is 47% undervalued
• Analyst price target for WVE is US$8.57 which is 2.2% above our fair value estimate

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Wave Life Sciences Ltd. (NASDAQ:WVE) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

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 Wave Life Sciences

What's The Estimated Valuation?

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	US$9.67m	US$14.9m	US$20.5m	US$26.1m	US$31.2m	US$35.7m	US$39.5m	US$42.7m	US$45.4m	US$47.6m
Growth Rate Estimate Source	Analyst x1	Est @ 53.54%	Est @ 38.07%	Est @ 27.25%	Est @ 19.67%	Est @ 14.36%	Est @ 10.65%	Est @ 8.05%	Est @ 6.23%	Est @ 4.95%
Present Value ($, Millions) Discounted @ 6.8%	US$9.1	US$13.0	US$16.8	US$20.1	US$22.5	US$24.1	US$25.0	US$25.2	US$25.1	US$24.7

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$206m

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 6.8%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$48m× (1 + 2.0%) ÷ (6.8%– 2.0%) = US$1.0b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$1.0b÷ ( 1 + 6.8%)¹⁰= US$524m

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$729m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$4.5, the company appears quite undervalued at a 47% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

Important Assumptions

We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual 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 Wave Life Sciences 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 0.800. 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.

SWOT Analysis for Wave Life Sciences

Moving On:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. 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 Wave Life Sciences, there are three important elements you should assess:

1. Risks: For instance, we've identified 4 warning signs for Wave Life Sciences (1 is a bit unpleasant) you should be aware of.
2. Future Earnings: How does WVE'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NASDAQGM every day. If you want to find the calculation for other stocks just search here.

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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.