Yahoo Finance OSI Systems Inc (NASDAQ:OSIS) Investors Are Paying Above The Intrinsic Value
Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of OSI Systems Inc (NASDAQ:OSIS) as an investment opportunity by projecting its future cash flows and then discounting them to today’s value. I will be using the Discounted Cash Flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. Please also note that this article was written in June 2018 so be sure check out the updated calculation by following the link below. Check out our latest analysis for OSI Systems
The model
I’m using the 2-stage growth model, which simply means we take in account two stages of company’s growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have perpetual stable growth rate. To start off with we need to estimate the next five years of cash flows. Where possible I use analyst estimates, but when these aren’t available I have extrapolated the previous free cash flow (FCF) from the year before. For this growth rate I used the average annual growth rate over the past five years, but capped at a reasonable level. I then discount the sum of these cash flows to arrive at a present value estimate.
5-year cash flow forecast
2018 | 2019 | 2020 | 2021 | 2022 | |
Levered FCF ($, Millions) | $83.06 | $91.07 | $88.67 | $91.54 | $94.50 |
Source | Analyst x3 | Analyst x3 | Analyst x2 | Extrapolated @ (3.23%) | Extrapolated @ (3.23%) |
Present Value Discounted @ 10.67% | $75.05 | $74.36 | $65.43 | $61.03 | $56.93 |
Present Value of 5-year Cash Flow (PVCF)= US$332.80m
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 the GDP. In this case I have used the 10-year government bond rate (2.9%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 10.7%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = US$94.50m × (1 + 2.9%) ÷ (10.7% – 2.9%) = US$1.26b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = US$1.26b ÷ ( 1 + 10.7%)5 = US$759.54m
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is US$1.09b. In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number. This results in an intrinsic value of $60.44. Compared to the current share price of $76.98, the stock is fair value, maybe slightly overvalued at the time of writing.
The assumptions
I’d like to 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 my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at OSI Systems as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 10.7%, which is based on a levered beta of 1.095. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Next Steps:
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. What is the reason for the share price to differ from the intrinsic value? For OSIS, I’ve compiled three key aspects you should further examine:
Financial Health: Does OSIS 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.
Future Earnings: How does OSIS’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: Are there other high quality stocks you could be holding instead of OSIS? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. Simply Wall St does a DCF calculation for every US stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.
