It's not possible to obtain a foolproof valuation with a DCF model. Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company.
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. Beta is a measure of a stock's volatility, compared to the market as a whole. In this calculation we've used 5.7%, which is based on a levered beta of 0.903. Given that we are looking at Surmodics 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.
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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. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own assumptions. Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Relative to the current share price of US$35.6, the company appears around fair value at the time of writing. To get the intrinsic value per share, we divide this by the total number of shares outstanding. The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$452m. 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 5.7%. In this case we have used the 5-year average of the 10-year government bond yield (1.9%) to estimate future growth. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. The second stage is also known as Terminal Value, this is the business's cash flow after the first stage.
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We do this to reflect that growth tends to slow more in the early years than it does in later years.Ī DCF is all about the idea that a dollar in the future is less valuable 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) estimate 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. 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. To start off with, we need to estimate the next ten years of cash flows. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth.
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