Key Insights

Using the 2 Stage Free Cash Flow to Equity, Capitol Health fair value estimate is AU$0.41 Current share price of AU$0.26 suggests Capitol Health is potentially 38% undervalued Our fair value estimate is 23% higher than Capitol Health's analyst price target of AU$0.33

How far off is Capitol Health Limited (ASX:CAJ) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by projecting its future cash flows and then discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

View our latest analysis for Capitol Health

The Model

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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:



10-year free cash flow (FCF) forecast

2023 2024 2025 2026 2027 2028 2029 2030 2031 2032 Levered FCF (A$, Millions)  AU$23.4m AU$20.1m AU$11.1m AU$20.1m AU$22.9m AU$24.5m AU$25.9m AU$27.1m AU$28.1m AU$29.0m Growth Rate Estimate Source Analyst x3 Analyst x4 Analyst x3 Analyst x1 Analyst x1 Est @ 7.19% Est @ 5.62% Est @ 4.51% Est @ 3.74% Est @ 3.19% Present Value (A$, Millions) Discounted @ 7.2%  AU$21.8 AU$17.4 AU$9.0 AU$15.2 AU$16.1 AU$16.1 AU$15.9 AU$15.5 AU$15.0 AU$14.4

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$157m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this 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 have used the 5-year average of the 10-year government bond yield (1.9%) 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 7.2%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = AU$29m× (1 + 1.9%) ÷ (7.2%– 1.9%) = AU$557m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$557m÷ ( 1 + 7.2%)10= AU$277m

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is AU$433m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of AU$0.3, the company appears quite undervalued at a 38% 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

Important Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Capitol Health 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 7.2%, which is based on a levered beta of 0.894. 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 Capitol Health

Strength

Debt is not viewed as a risk.

Weakness

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

Opportunity

Expected to breakeven next year.

Has sufficient cash runway for more than 3 years based on current free cash flows.

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

Threat

Paying a dividend but company is unprofitable.

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching 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 example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Capitol Health, we've put together three fundamental factors you should consider:

Risks: For example, we've discovered 1 warning sign for Capitol Health that you should be aware of before investing here. Future Earnings: How does CAJ'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 ASX 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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