An Intrinsic Calculation For Elanco Animal Health Incorporated (NYSE:ELAN) Suggests It's 29% Undervalued

By
Simply Wall St
Published
September 08, 2021

In this article we are going to estimate the intrinsic value of Elanco Animal Health Incorporated (NYSE:ELAN) by estimating the company's future cash flows and discounting them to their present 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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Elanco Animal Health

Is Elanco Animal Health fairly valued?

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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.

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) estimate

 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 Levered FCF (\$, Millions) US\$601.0m US\$714.5m US\$798.2m US\$868.4m US\$927.1m US\$976.5m US\$1.02b US\$1.06b US\$1.09b US\$1.12b Growth Rate Estimate Source Analyst x2 Analyst x2 Est @ 11.72% Est @ 8.8% Est @ 6.76% Est @ 5.33% Est @ 4.33% Est @ 3.62% Est @ 3.13% Est @ 2.79% Present Value (\$, Millions) Discounted @ 6.0% US\$567 US\$636 US\$670 US\$688 US\$693 US\$688 US\$678 US\$662 US\$645 US\$625

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US\$6.6b

The second stage is also known as Terminal Value, this is the business's cash flow after 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 6.0%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US\$1.1b× (1 + 2.0%) ÷ (6.0%– 2.0%) = US\$28b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US\$28b÷ ( 1 + 6.0%)10= US\$16b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US\$22b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US\$33.9, the company appears a touch undervalued at a 29% 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 assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 Elanco Animal Health 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 6.0%, which is based on a levered beta of 0.849. 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?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Elanco Animal Health, there are three important factors you should further research:

1. Risks: Every company has them, and we've spotted 1 warning sign for Elanco Animal Health you should know about.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for ELAN's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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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