Are Investors Undervaluing The a2 Milk Company Limited (NZSE:ATM) By 49%?

Key Insights

• a2 Milk's estimated fair value is NZ$11.35 based on 2 Stage Free Cash Flow to Equity

• a2 Milk is estimated to be 49% undervalued based on current share price of NZ$5.77

• Analyst price target for ATM is NZ$6.90 which is 39% below our fair value estimate

Today we will run through one way of estimating the intrinsic value of The a2 Milk Company Limited (NZSE:ATM) by estimating the company's future cash flows and discounting them to their present value. Our analysis will employ the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

See our latest analysis for a2 Milk

The Calculation

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

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (NZ$, Millions)	NZ$36.8m	NZ$194.3m	NZ$201.1m	NZ$278.7m	NZ$349.2m	NZ$402.0m	NZ$447.3m	NZ$485.6m	NZ$517.9m	NZ$545.5m
Growth Rate Estimate Source	Analyst x3	Analyst x3	Analyst x3	Analyst x2	Analyst x1	Est @ 15.13%	Est @ 11.26%	Est @ 8.55%	Est @ 6.66%	Est @ 5.33%
Present Value (NZ$, Millions) Discounted @ 7.0%	NZ$34.4	NZ$170	NZ$164	NZ$213	NZ$249	NZ$268	NZ$279	NZ$283	NZ$282	NZ$278

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NZ$2.2b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 (2.2%) 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 7.0%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = NZ$545m× (1 + 2.2%) ÷ (7.0%– 2.2%) = NZ$12b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= NZ$12b÷ ( 1 + 7.0%)¹⁰= NZ$6.0b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is NZ$8.2b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of NZ$5.8, 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.

dcf

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 a2 Milk 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 7.0%, 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 a2 Milk

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is not viewed as a risk.

Weakness

• No major weaknesses identified for ATM.

Opportunity

• Annual earnings are forecast to grow faster than the New Zealander market.

• Trading below our estimate of fair value by more than 20%.

Threat

• Revenue is forecast to grow slower than 20% per year.

Next Steps:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. Why is the intrinsic value higher than the current share price? For a2 Milk, we've put together three relevant elements you should consider:

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: 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 NZSE every day. If you want to find the calculation for other stocks 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.

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