In this article we are going to estimate the intrinsic value of Hikma Pharmaceuticals PLC (LON:HIK) by taking the expected future cash flows and discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Don't get put off by the jargon, the math behind it is actually quite straightforward.
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 still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
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. To begin with, we have to get estimates of the next ten years of cash flows. 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 need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) estimate
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
Levered FCF ($, Millions)
US$517.3m
US$542.3m
US$454.0m
US$477.0m
US$466.0m
US$461.4m
US$461.2m
US$463.9m
US$468.8m
US$475.2m
Growth Rate Estimate Source
Analyst x5
Analyst x5
Analyst x1
Analyst x1
Est @ -2.31%
Est @ -0.98%
Est @ -0.05%
Est @ 0.59%
Est @ 1.05%
Est @ 1.37%
Present Value ($, Millions) Discounted @ 6.0%
US$488
US$483
US$381
US$378
US$348
US$325
US$307
US$291
US$278
US$266
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = US$3.5b
After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 6.0%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$13b÷ ( 1 + 6.0%)10= US$7.0b
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$11b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£19.5, the company appears quite undervalued at a 49% 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.
LSE:HIK Discounted Cash Flow November 23rd 2024
The 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. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Hikma 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 6.0%, 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 Hikma Pharmaceuticals
Strength
Earnings growth over the past year exceeded the industry.
Debt is well covered by earnings and cashflows.
Dividends are covered by earnings and cash flows.
Weakness
Dividend is low compared to the top 25% of dividend payers in the Pharmaceuticals market.
Opportunity
Annual revenue is forecast to grow faster than the British market.
Good value based on P/E ratio and estimated fair value.
Threat
Annual earnings are forecast to grow slower than the British market.
Moving On:
Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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 Hikma Pharmaceuticals, we've put together three important items you should further research:
Future Earnings: How does HIK'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. Simply Wall St updates its DCF calculation for every British stock every day, so if you want to find the intrinsic value of any other stock just search here.
Have feedback on this article? Concerned about the content?Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.
