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The a2 Milk Company Limited (NZSE:ATM) Shares Could Be 33% Below Their Intrinsic Value Estimate

Key Insights

  • The projected fair value for a2 Milk is NZ$11.39 based on 2 Stage Free Cash Flow to Equity

  • Current share price of NZ$7.67 suggests a2 Milk is potentially 33% undervalued

  • Analyst price target for ATM is NZ$6.64 which is 42% 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 taking the forecast future cash flows of the company and discounting them back to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. There's really not all that much to it, even though it might appear quite complex.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

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View our latest analysis for a2 Milk

The Calculation

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. To begin with, we have to get estimates of the next ten years of cash flows. 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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

2024

2025

2026

2027

2028

2029

2030

2031

2032

2033

Levered FCF (NZ$, Millions)

NZ$166.3m

NZ$174.9m

NZ$214.9m

NZ$261.7m

NZ$299.9m

NZ$328.6m

NZ$353.2m

NZ$374.6m

NZ$393.4m

NZ$410.4m

Growth Rate Estimate Source

Analyst x5

Analyst x5

Analyst x5

Analyst x3

Analyst x3

Est @ 9.56%

Est @ 7.49%

Est @ 6.04%

Est @ 5.03%

Est @ 4.32%

Present Value (NZ$, Millions) Discounted @ 6.4%

NZ$156

NZ$155

NZ$179

NZ$205

NZ$220

NZ$227

NZ$230

NZ$229

NZ$226

NZ$222

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NZ$2.0b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.7%. We discount the terminal cash flows to today's value at a cost of equity of 6.4%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = NZ$410m× (1 + 2.7%) ÷ (6.4%– 2.7%) = NZ$11b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= NZ$11b÷ ( 1 + 6.4%)10= NZ$6.2b

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. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of NZ$7.7, the company appears quite good value at a 33% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

dcf
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 6.4%, 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 revenue is forecast to grow faster than the New Zealander market.

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

Threat

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

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. The DCF model is not a perfect stock valuation tool. 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 a2 Milk, we've compiled three additional items 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 Solid Businesses: 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 business fundamentals to see if there are other companies you may not have considered!

PS. Simply Wall St updates its DCF calculation for every New Zealander stock every day, so if you want to find the intrinsic value of any other stock 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.