Are Investors Undervaluing Illumina, Inc. (NASDAQ:ILMN) By 48%?

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Today we’ll do a simple run through of a valuation method used to estimate the attractiveness of Illumina, Inc. (NASDAQ:ILMN) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back to today’s value. Our analysis will employ the Discounted Cash Flow (DCF) model. There’s really not all that much to it, even though it might appear quite complex.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

See our latest analysis for Illumina

Step By Step Through The Calculation

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 ($, Millions)

US$1.15b

US$1.24b

US$1.76b

US$2.13b

US$2.40b

US$2.63b

US$2.83b

US$2.99b

US$3.13b

US$3.24b

Growth Rate Estimate Source

Analyst x3

Analyst x4

Analyst x2

Analyst x2

Est @ 12.91%

Est @ 9.62%

Est @ 7.32%

Est @ 5.7%

Est @ 4.57%

Est @ 3.78%

Present Value ($, Millions) Discounted @ 5.9%

US$1.1k

US$1.1k

US$1.5k

US$1.7k

US$1.8k

US$1.9k

US$1.9k

US$1.9k

US$1.9k

US$1.8k

(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$16b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 1.9%. We discount the terminal cash flows to today’s value at a cost of equity of 5.9%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$3.2b× (1 + 1.9%) ÷ (5.9%– 1.9%) = US$83b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$83b÷ ( 1 + 5.9%)10= US$47b

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$63b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$207, the company appears quite undervalued at a 48% 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

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. 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. 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 Illumina 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 5.9%, which is based on a levered beta of 0.941. 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.

Next Steps:

Although the valuation of a company is important, it 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. 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. Can we work out why the company is trading at a discount to intrinsic value? For Illumina, we’ve put together three fundamental aspects you should look at:

  1. Risks: Consider for instance, the ever-present spectre of investment risk. We’ve identified 2 warning signs with Illumina , and understanding these should be part of your investment process.

  2. Future Earnings: How does ILMN’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 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. Simply Wall St updates its DCF calculation for every American stock every day, so if you want to find the intrinsic value of any other stock 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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