Eli Lilly and Company's (NYSE:LLY) Intrinsic Value Is Potentially 52% Above Its Share Price

By
Simply Wall St
Published
April 01, 2021
NYSE:LLY

In this article we are going to estimate the intrinsic value of Eli Lilly and Company (NYSE:LLY) by taking the expected future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

View our latest analysis for Eli Lilly

The method

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
Levered FCF ($, Millions) US$7.10b US$7.59b US$7.95b US$9.17b US$10.5b US$11.4b US$12.2b US$12.8b US$13.3b US$13.8b
Growth Rate Estimate Source Analyst x8 Analyst x8 Analyst x7 Analyst x4 Analyst x4 Est @ 8.55% Est @ 6.6% Est @ 5.23% Est @ 4.27% Est @ 3.6%
Present Value ($, Millions) Discounted @ 6.2% US$6.7k US$6.7k US$6.6k US$7.2k US$7.8k US$7.9k US$8.0k US$7.9k US$7.7k US$7.6k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$74b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 6.2%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$14b× (1 + 2.0%) ÷ (6.2%– 2.0%) = US$337b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$337b÷ ( 1 + 6.2%)10= US$184b

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$258b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of US$187, the company appears quite undervalued at a 34% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf
NYSE:LLY Discounted Cash Flow April 1st 2021

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Eli Lilly 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 6.2%, 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.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and 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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Can we work out why the company is trading at a discount to intrinsic value? For Eli Lilly, we've compiled three important factors you should further examine:

  1. Risks: For instance, we've identified 1 warning sign for Eli Lilly that you should be aware of.
  2. Future Earnings: How does LLY'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 NYSE 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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