CVS Health Corporation's (NYSE:CVS) Intrinsic Value Is Potentially 99% Above Its Share Price

Key Insights

• The projected fair value for CVS Health is US$153 based on 2 Stage Free Cash Flow to Equity

• Current share price of US$77.10 suggests CVS Health is potentially 50% undervalued

• Analyst price target for CVS is US$113 which is 26% below our fair value estimate

How far off is CVS Health Corporation (NYSE:CVS) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. 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 CVS Health

Crunching The Numbers

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.

A 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) forecast

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	US$11.1b	US$11.4b	US$11.4b	US$12.1b	US$12.5b	US$12.8b	US$13.0b	US$13.3b	US$13.6b	US$13.9b
Growth Rate Estimate Source	Analyst x6	Analyst x3	Analyst x3	Analyst x2	Analyst x2	Est @ 2.33%	Est @ 2.25%	Est @ 2.20%	Est @ 2.16%	Est @ 2.13%
Present Value ($, Millions) Discounted @ 7.9%	US$10.3k	US$9.8k	US$9.0k	US$9.0k	US$8.5k	US$8.1k	US$7.7k	US$7.3k	US$6.9k	US$6.5k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$83b

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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 7.9%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$14b× (1 + 2.1%) ÷ (7.9%– 2.1%) = US$244b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$244b÷ ( 1 + 7.9%)¹⁰= US$114b

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 US$197b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of US$77.1, the company appears quite undervalued at a 50% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf

Important 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 CVS 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 7.9%, which is based on a levered beta of 0.980. 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 CVS Health

Strength

• Debt is well covered by earnings and cashflows.

• Dividends are covered by earnings and cash flows.

Weakness

• Earnings declined over the past year.

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

Opportunity

• Annual earnings are forecast to grow faster than the American market.

• Good value based on P/E ratio and estimated fair value.

Threat

• Annual revenue is forecast to grow slower than the American market.

Next Steps:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For CVS Health, we've put together three further elements you should explore:

1. Risks: We feel that you should assess the 3 warning signs for CVS Health we've flagged before making an investment in the company.

2. Future Earnings: How does CVS'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NYSE 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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