Today I will be providing a simple run-through of the discounted cash flows (DCF) method to estimate the attractiveness of The a2 Milk Company Limited (NZSE:ATM) as an investment opportunity. If you want to learn more about this method, the basis for my calculations can be found in detail in the Simply Wall St analysis model. If you are reading this after March 2018 then I highly recommend you check out the latest calculation for a2 Milk here.

Crunching the numbers

I use what is known as the 2-stage 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. Firstly, I pulled together the analyst consensus estimates of ATM’s levered free cash flow (FCF) over the next five years and discounted these figures at the rate of 8.55%. When estimates weren’t available, I’ve extrapolated the average annual growth rate over the previous five years, capped at a reasonable level. This resulted in a present value of 5-year cash flow of NZ$1.24B. Want to understand how I calculated this value? Check out our detailed analysis here.

Above is a visual representation of how ATM’s earnings are expected to move in the future, which should give you some color on ATM’s outlook. Then, I calculate the terminal value, which is the business’s cash flow after the first stage. I think it’s suitable to use the 10-year government bond rate of 2.8% as the stable growth rate, which is rightly below GDP growth, but more towards the conservative side. Discounting the terminal value back five years gives us a present value of NZ$5.38B.

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 NZ$6.62B. The last step is to then divide the equity value by the number of shares outstanding. This results in an intrinsic value of NZ$9.05, which, compared to the current share price of NZ$13.18, we find that a2 Milk is rather overvalued and not available at a discount at this time.

Next Steps:

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. What is the reason for the share price to differ from the intrinsic value? For ATM, I’ve compiled three essential aspects you should further research:

1. Financial Health: Does ATM 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.

2. Future Earnings: How does ATM’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: Are there other high quality stocks you could be holding instead of ATM? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!