Key Insights

The projected fair value for AFT Pharmaceuticals is NZ$3.31 based on 2 Stage Free Cash Flow to Equity Current share price of NZ$3.80 suggests AFT Pharmaceuticals is potentially trading close to its fair value Our fair value estimate is 21% lower than AFT Pharmaceuticals' analyst price target of NZ$4.17

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of AFT Pharmaceuticals Limited (NZSE:AFT) as an investment opportunity by estimating the company's future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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.

See our latest analysis for AFT Pharmaceuticals

What's The Estimated Valuation?

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. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 Levered FCF (NZ$, Millions)  NZ$5.20m NZ$9.50m NZ$3.80m NZ$12.2m NZ$14.7m NZ$17.0m NZ$18.9m NZ$20.5m NZ$21.8m NZ$23.0m Growth Rate Estimate Source Analyst x1 Analyst x1 Analyst x1 Analyst x1 Est @ 20.69% Est @ 15.15% Est @ 11.28% Est @ 8.56% Est @ 6.66% Est @ 5.33% Present Value (NZ$, Millions) Discounted @ 7.0%  NZ$4.9 NZ$8.3 NZ$3.1 NZ$9.3 NZ$10.5 NZ$11.3 NZ$11.8 NZ$11.9 NZ$11.9 NZ$11.7

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NZ$95m

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 7.0%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = NZ$23m× (1 + 2.2%) ÷ (7.0%– 2.2%) = NZ$495m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= NZ$495m÷ ( 1 + 7.0%)10= NZ$252m

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$347m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of NZ$3.8, the company appears around fair value at the time of writing. 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

The 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. If you don't agree with these result, have a go at the calculation yourself and play with the assumptions. 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 AFT Pharmaceuticals 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 7.0%, 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 AFT Pharmaceuticals

Strength

Debt is well covered by earnings and cashflows.

Weakness

Earnings declined over the past year.

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

Current share price is above our estimate of fair value.

Opportunity

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

Threat

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

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess 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. For AFT Pharmaceuticals, we've put together three essential items you should look at:

Risks: Take risks, for example - AFT Pharmaceuticals has  2 warning signs  we think you should be aware of. Future Earnings: How does AFT'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. 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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NZSE every day. If you want to find the calculation for other stocks 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.

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