Today we’re going to review one way to estimate the intrinsic value of Oak Street Health, Inc. (NYSE: OSH) by taking expected future cash flows and discounting them to today’s value. . One way to do this is to use the Discounted Cash Flow (DCF) model. Believe it or not, it’s not too hard to follow, as you will see in our example!
Remember, however, that there are many ways to estimate the value of a business, and a DCF is just one method. If you still have burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
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We use the 2-step growth model, which simply means that we take into account two stages of business growth. In the initial period, the business can have a higher growth rate, and the second stage is usually assumed to have a stable growth rate. To begin with, we need to get cash flow estimates for the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated 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 down more in the early years than in subsequent years.
In general, we assume that a dollar today is worth more than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at an estimate of the present value:
10-year Free Cash Flow (FCF) estimate
|Leverage FCF ($, Millions)||-154.3 million US dollars||-32.9 million US dollars||US $ 136.9 million||US $ 334.1 million||US $ 516.4 million||US $ 716.8 million||US $ 915.8 million||US $ 1.10 billion||US $ 1.26 billion||US $ 1.40 billion|
|Source of estimated growth rate||Analyst x5||Analyst x4||Analyst x2||Analyst x2||East @ 54.57%||East @ 38.8%||Est @ 27.76%||Est @ 20.03%||Est @ 14.62%||Est @ 10.83%|
|Present value (in millions of dollars) discounted at 6.0%||– $ 146||– $ 29.3||115 USD||US $ 265||$ 387||507 USD||US $ 611||US $ 692||US $ 748||US $ 783|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 3.9 billion
It is now a matter of calculating the Terminal Value, which takes into account all 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 used the 5-year average of the 10-year government bond yield (2.0%) to estimate future growth. Similar to the 10-year âgrowthâ period, we discount future cash flows to their present value, using a cost of equity of 6.0%.
Terminal value (TV)= FCF2031 Ã (1 + g) Ã· (r – g) = US $ 1.4 billion Ã (1 + 2.0%) Ã· (6.0% – 2.0%) = US $ 36 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= US $ 36 billion Ã· (1 + 6.0%)ten= US $ 20 billion
Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is $ 24 billion. In the last step, we divide the equity value by the number of shares outstanding. From the current share price of US $ 59.6, the company looks fairly good value with a 40% discount from the current share price. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.
Now the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. Part of investing is coming up with your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a full picture of a company’s potential performance. Since we view Oak Street 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 takes into account debt. . In this calculation, we used 6.0%, which is based on a leveraged beta of 0.840. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
While a business valuation is important, ideally it won’t be the only analysis you review for a business. DCF models are not the alpha and omega of investment valuation. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. What is the reason why the stock price is lower than intrinsic value? For Oak Street Health, we’ve put together three other things you should explore:
- Risks: Consider, for example, the ever-present specter of investment risk. We have identified 2 warning signs with Oak Street Health, and understanding them should be part of your investment process.
- Management: Have insiders increased their stocks to take advantage of market sentiment about OSH’s future prospects? Check out our management and board analysis with information on CEO compensation and governance factors.
- Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what you might be missing!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for every NYSE share. If you want to find the calculation for other actions, just search here.
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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in any of the stocks mentioned.
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