Today we will run through one way of estimating the intrinsic value of Xenon Pharmaceuticals Inc. (NASDAQ:XENE) by estimating the company's future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. 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.
Is Xenon Pharmaceuticals fairly valued?
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, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
|Levered FCF ($, Millions)||-US$69.0m||-US$35.0m||-US$22.0m||US$15.0m||US$23.0m||US$31.7m||US$40.4m||US$48.3m||US$55.3m||US$61.3m|
|Growth Rate Estimate Source||Analyst x1||Analyst x1||Analyst x1||Analyst x1||Est @ 53.29%||Est @ 37.97%||Est @ 27.24%||Est @ 19.74%||Est @ 14.48%||Est @ 10.8%|
|Present Value ($, Millions) Discounted @ 8.1%||-US$63.8||-US$29.9||-US$17.4||US$11.0||US$15.5||US$19.8||US$23.3||US$25.8||US$27.4||US$28.0|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$39m
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 2.2%. We discount the terminal cash flows to today's value at a cost of equity of 8.1%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$61m× (1 + 2.2%) ÷ (8.1%– 2.2%) = US$1.1b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$1.1b÷ ( 1 + 8.1%)10= US$484m
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$523m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$11.0, the company appears a touch undervalued at a 26% 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.
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 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 Xenon Pharmaceuticals 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 8.1%, which is based on a levered beta of 0.985. 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.
Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" 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 Xenon Pharmaceuticals, we've compiled three relevant aspects you should explore:
- Risks: You should be aware of the 3 warning signs for Xenon Pharmaceuticals (1 shouldn't be ignored!) we've uncovered before considering an investment in the company.
- Future Earnings: How does XENE'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: 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. 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.
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