A look at the fair value of Laboratory Corporation of America Holdings (NYSE: LH)
Today we’re going to review one way to estimate the intrinsic value of Laboratory Corporation of America Holdings (NYSE: LH) by taking the expected future cash flows of the company and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Before you think you won’t be able to figure it out, read on! It’s actually a lot less complex than you might imagine.
We would like to point out that there are many ways to assess a business and, like DCF, each technique has advantages and disadvantages in certain scenarios. Anyone interested in learning a little more about intrinsic value should have a read of the Simply Wall St.
Step by step in the calculation
We use what is called a 2-step model, which simply means that we have two different periods of growth rate for the cash flow of the business. Usually the first stage is higher growth and the second stage is lower growth stage. First, we need to estimate the cash flow of the business over 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 the last reported value. We assume that companies with decreasing free cash flow will slow their withdrawal rate, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect that growth tends to slow down more in the early years than in the later years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, and therefore the sum of these future cash flows is then discounted to present value:
10-year free cash flow (FCF) estimate
2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | |
Levered FCF ($, million) | $ 1.91 billion | $ 1.42 billion | $ 1.44 billion | 1.51 billion USD | 1.59 billion USD | $ 1.64 billion | $ 1.69 billion | $ 1.73 billion | $ 1.78 billion | $ 1.82 billion |
Source of estimated growth rate | Analyst x5 | Analyst x5 | Analyst x4 | Analyst x1 | Analyst x1 | Is at 3.26% | Is 2.89% | Is 2.64% | East @ 2.46% | Is 2.33% |
Present value (in millions of dollars) discounted at 6.8% | US $ 1.8K | US $ 1.2K | US $ 1.2K | US $ 1.2K | US $ 1.1K | US $ 1.1K | US $ 1.1K | US $ 1.0k | US $ 982 | US $ 941 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flow (PVCF) = 12 billion USD
Now we need to calculate the terminal value, which takes into account all future cash flows after that 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 “growth” period, we discount future cash flows to present value, using a cost of equity of 6.8%.
Terminal value (TV)= FCF_{2030} × (1 + g) ÷ (r – g) = $ 1.8 billion × (1 + 2.0%) ÷ (6.8% – 2.0%) = $ 39 billion
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= 39 billion USD ÷ (1 + 6.8%)^{ten}= 20 billion USD
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total value of equity, which in this case is US $ 32 billion. The last step is then to divide the equity value by the number of shares outstanding. From the current share price of US $ 261, the company appears to have fair value at a 20% discount from the current share price. The assumptions in any calculation have a big impact on the valuation, so it’s best to take this as a rough estimate, not precise down to the last penny.
NYSE: LH Discounted Cash Flow April 23, 2021
The hypotheses
We draw your attention to the fact that the most important data for a discounted cash flow is the discount rate and of course the actual cash flow. If you don’t agree with these results, try the calculation yourself and play with the 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 complete picture of a company’s potential performance. Since we view Laboratory Corporation of America Holdings 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 6.8%, which is based on a leveraged beta of 0.911. Beta is a measure of the volatility of a stock, relative 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.
Looking forward:
Valuation is only one side of the coin in terms of building your investment thesis, and it’s just one of the many factors you need to evaluate for a business. DCF models are not the alpha and omega of investment valuation. Preferably, you would apply different cases and assumptions and see how they would impact the valuation of the business. For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. For Laboratory Corporation of America Holdings, there are three additional aspects to consider:
- Risks: Every company has them, and we have spotted 4 warning signs for Laboratory Corporation of America Holdings (of which 1 should not be ignored!) that you should know.
- Future income: How does LH’s growth rate compare to its peers and the market in general? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth forecast chart.
- Other strong companies: Low debt, high return on equity, and good past performance are essential to a strong business. Why not explore our interactive list of stocks with solid trading fundamentals to see if there are other companies you may not have considered!
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.
This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take into account your goals or your financial situation. We aim 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 information. Simply Wall St has no position in any of the stocks mentioned.
Do you have any comments on this article? Concerned about the content? Get in touch with us directly. You can also send an email to the editorial team (at) simplywallst.com.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.