Are investors undervaluing Addus HomeCare Corporation (NASDAQ:ADUS) by 42%?
Today we are going to do a simple overview of a valuation method used to estimate the attractiveness of Addus HomeCare Corporation (NASDAQ:ADUS) as an investment opportunity by taking cash flow expected futures and discounting them to their present 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’ll see in our example!
We draw your attention to the fact that there are many ways to value a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. 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 review for Addus HomeCare
The calculation
We use what is called a 2-stage 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 start, we need to estimate the cash flows 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.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, 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
2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | |
Leveraged FCF ($, millions) | $64.1 million | $71.2 million | $80.0 million | $86.5 million | $91.9 million | $96.5 million | $100.4 million | $103.9 million | $107.0 million | $109.8 million |
Growth rate estimate Source | Analyst x4 | Analyst x3 | Analyst x1 | Is at 8.11% | Is at 6.27% | Is at 4.97% | Is at 4.07% | Is at 3.44% | Is 2.99% | Is at 2.68% |
Present value (in millions of dollars) discounted at 6.0% | $60.5 | $63.3 | $67.2 | $68.5 | $68.7 | $68.0 | $66.8 | $65.2 | $63.3 | $61.4 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $652 million
After calculating the present value of future cash flows over the initial 10-year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first stage. 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 2.0%. We discount terminal cash flows to present value at a cost of equity of 6.0%.
Terminal value (TV)= FCF_{2031} × (1 + g) ÷ (r – g) = US$110 million × (1 + 2.0%) ÷ (6.0%–2.0%) = US$2.8 billion
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= $2.8 billion ÷ (1 + 6.0%)^{ten}= $1.6 billion
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is $2.2 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of $80.5, the company looks quite undervalued at a 42% discount to the current share price. 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.
Important assumptions
Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flows. 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, 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 Addus HomeCare 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 6.0%, which is based on a leveraged beta of 0.921. 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.
Next steps:
While important, the DCF calculation will ideally not be the only piece of analysis you look at for a business. It is not possible to obtain an infallible valuation with a DCF model. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under/overvalued?” For example, if the terminal value growth rate is adjusted slightly, it can significantly change the overall result. Can we understand why the company is trading at a discount to its intrinsic value? For Addus HomeCare, we’ve compiled three fundamental things to consider:
- Risks: For example, we spotted 1 warning sign for Addus HomeCare you should be aware.
- Future earnings: How does ADUS’ growth rate compare to its peers and the broader market? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
- 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. Simply Wall St updates its DCF calculation for every US stock daily, so if you want to find the intrinsic value of any other stock, do a 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.