How far is Grifols, SA (BME: GRF) from its intrinsic value? Using the most recent financial data, we’ll examine whether the stock price is fair by taking the company’s future cash flow forecast and discounting it to today’s value. To this end, we will take advantage of the Discounted Cash Flow (DCF) model. There really isn’t much to do, although it might seem quite complex.

There are many ways that businesses can be assessed, so we would like to stress that a DCF is not perfect for all situations. Anyone interested in learning a little more about intrinsic value should read the Simply Wall St.

Check out our latest analysis for Grifols

The model

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 estimate the next ten years of cash flow. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous Free Cash Flow (FCF) from the latest 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.

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 today’s value:

10-year Free Cash Flow (FCF) estimate

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = € 6.5bn

The second stage is also known as terminal value, this is the cash flow of the business after 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 of the 10-year government bond yield of 1.0%. We discount the terminal cash flows to their present value at a cost of equity of 8.8%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = € 1.2 billion × (1 + 1.0%) ÷ (8.8% – 1.0%) = € 16 billion

Present value of terminal value (PVTV)= TV / (1 + r)^ten= € 16bn ÷ (1 + 8.8%)^ten= € 6.8bn

The total value is the sum of the cash flows of the next ten years plus the present terminal value, which gives the Total Equity Value, which in this case is 13 billion euros. The last step is then to divide the equity value by the number of shares outstanding. Compared to the current stock price of € 21.7, the company appears to be around fair value at the time of writing. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.

Important assumptions

Now, the most important inputs to a discounted cash flow are 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 full picture of a company’s potential performance. Since we view Grifols 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 debt into account. In this calculation, we used 8.8%, which is based on a leveraged beta of 1.240. 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.

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 ultimate solution for investment valuation. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. 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. For Grifols, we’ve compiled three more things you should dig into:

1. Risks: Note that Grifols displays 2 warning signs in our investment analysis , and 1 of them doesn’t go too well with us …
2. Future benefits: How does GRF’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth expectations chart.
3. Other strong companies: Low debt, high returns on equity and good past performance are fundamental 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. Simply Wall St updates its DCF calculation for every Spanish stock every day, so if you want to find the intrinsic value of any other stock 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 material. Simply Wall St has no position in the mentioned stocks.
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