Sonic Healthcare Limited's (ASX:SHL) Intrinsic Value Is Potentially 98% Above Its Share Price

Key Insights

• Sonic Healthcare's estimated fair value is AU$53.50 based on 2 Stage Free Cash Flow to Equity

• Sonic Healthcare is estimated to be 49% undervalued based on current share price of AU$27.07

• Analyst price target for SHL is AU$30.69 which is 43% below our fair value estimate

Today we will run through one way of estimating the intrinsic value of Sonic Healthcare Limited (ASX:SHL) by estimating the company's future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

View our latest analysis for Sonic Healthcare

Step By Step Through The Calculation

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. 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, 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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	AU$755.4m	AU$990.3m	AU$1.07b	AU$997.5m	AU$1.05b	AU$1.07b	AU$1.09b	AU$1.11b	AU$1.13b	AU$1.15b
Growth Rate Estimate Source	Analyst x7	Analyst x7	Analyst x7	Analyst x2	Analyst x2	Est @ 1.45%	Est @ 1.66%	Est @ 1.81%	Est @ 1.92%	Est @ 1.99%
Present Value (A$, Millions) Discounted @ 5.8%	AU$714	AU$884	AU$902	AU$795	AU$793	AU$760	AU$730	AU$702	AU$676	AU$652

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$7.6b

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 5.8%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$1.1b× (1 + 2.2%) ÷ (5.8%– 2.2%) = AU$32b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$32b÷ ( 1 + 5.8%)¹⁰= AU$18b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is AU$26b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of AU$27.1, the company appears quite good value at a 49% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf

Important 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. 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 Sonic Healthcare 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 5.8%, 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 Sonic Healthcare

Strength

• Debt is not viewed as a risk.

Weakness

• Earnings declined over the past year.

• Dividend is low compared to the top 25% of dividend payers in the Healthcare market.

• Shareholders have been diluted in the past year.

Opportunity

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

• Good value based on P/E ratio and estimated fair value.

Threat

• Dividends are not covered by earnings.

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

Moving On:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. 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. What is the reason for the share price sitting below the intrinsic value? For Sonic Healthcare, we've compiled three fundamental factors you should look at:

1. Risks: To that end, you should be aware of the 3 warning signs we've spotted with Sonic Healthcare .

2. Future Earnings: How does SHL'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. Simply Wall St updates its DCF calculation for every Australian stock every day, so if you want to find the intrinsic value of any other stock just search here.

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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.