Does West Pharmaceutical Services, Inc.’s (NYSE:WST) stock price in September reflect what it’s really worth? Today we are going to estimate the intrinsic value of the stock by projecting its future cash flows and then discounting them to the present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Patterns like these may seem beyond a layman’s comprehension, but they’re pretty easy to follow.
Businesses can be valued in many ways, which is why we emphasize that a DCF is not perfect for all situations. If you still have burning questions about this type of assessment, take a look at Simply Wall St.’s analysis template.
Check out our latest analysis for West Pharmaceutical Services
Step by step through the calculation
We use what is called a 2-step model, which simply means that we have two different periods of company cash flow growth rates. Generally, the first stage is a higher growth phase and the second stage is a lower growth phase. To begin with, we need to obtain cash flow estimates for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.
Generally, we assume that a dollar today is worth more 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) Forecast
|Leveraged FCF ($, millions)||US$533.1 million||$628.1 million||$629.0 million||$694.0 million||US$735.9 million||$771.2 million||$801.7 million||$828.5 million||$852.7 million||$875.1 million|
|Growth rate estimate Source||Analyst x2||Analyst x2||Analyst x1||Analyst x1||Is at 6.03%||Is at 4.81%||Is 3.95%||Is at 3.34%||Is at 2.92%||Is at 2.63%|
|Present value (in millions of dollars) discounted at 5.9%||$503||$560||$529||$552||$552||$546||$536||$523||$509||$493|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $5.3 billion
We now need to calculate the terminal value, which represents all future cash flows after this ten-year period. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 1.9%. We discount terminal cash flows to present value at a cost of equity of 5.9%.
Terminal value (TV)= FCF2032 × (1 + g) ÷ (r – g) = $875 million × (1 + 1.9%) ÷ (5.9%–1.9%) = $22 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= $22 billion ÷ (1 + 5.9%)ten= $13 billion
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is $18 billion. The final step is to divide the equity value by the number of shares outstanding. Compared to the current share price of US$293, the company appears slightly overvalued at the time of writing. The assumptions of any calculation have a big impact on the valuation, so it’s best to consider this as a rough estimate, not accurate down to the last penny.
The above calculation is highly dependent on two assumptions. One is the discount rate and the other is the cash flows. If you disagree with these results, try the math yourself and play around with the assumptions. The DCF also does not take into account the possible cyclicality of an industry, nor the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view West Pharmaceutical Services 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 factors in debt. In this calculation, we used 5.9%, which is based on a leveraged beta of 0.937. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Valuation is only one side of the coin in terms of building your investment thesis, and it’s just one of many factors you need to assess for a company. The DCF model is not a perfect stock valuation tool. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, if the terminal value growth rate is adjusted slightly, it can significantly change the overall result. What is the reason why the stock price exceeds the intrinsic value? For West Pharmaceutical Services, we’ve rounded up three additional things you should consider:
- Risks: For example, we found 1 warning sign for West Pharmaceutical Services that you must consider before investing here.
- Management: Did insiders increase their shares to take advantage of market sentiment regarding WST’s future prospects? View our management and board analysis with insights into CEO compensation and governance factors.
- Other strong companies: Low debt, high returns on equity and good past performance are essential to a strong business. Why not explore our interactive list of stocks with strong trading fundamentals to see if there are any other companies you may not have considered!
PS. The Simply Wall St app performs a discounted cash flow valuation for every stock on the NYSE every day. If you want to find the calculation for other stocks, search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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