Are Investors Undervaluing McKesson Corporation (NYSE:MCK) By 44%?

McKesson Corporation +1.16%

McKesson Corporation

MCK

516.24

+1.16%

Key Insights

  • McKesson's estimated fair value is US$804 based on 2 Stage Free Cash Flow to Equity
  • Current share price of US$448 suggests McKesson is potentially 44% undervalued
  • The US$478 analyst price target for MCK is 41% less than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of McKesson Corporation (NYSE:MCK) by taking the expected future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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 McKesson

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. To start off with, we need to estimate 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.

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) forecast

2024 2025 2026 2027 2028 2029 2030 2031 2032 2033
Levered FCF ($, Millions) US$3.92b US$4.32b US$4.54b US$4.29b US$4.75b US$4.85b US$4.96b US$5.07b US$5.18b US$5.30b
Growth Rate Estimate Source Analyst x5 Analyst x5 Analyst x5 Analyst x2 Analyst x3 Est @ 2.26% Est @ 2.23% Est @ 2.20% Est @ 2.19% Est @ 2.18%
Present Value ($, Millions) Discounted @ 6.2% US$3.7k US$3.8k US$3.8k US$3.4k US$3.5k US$3.4k US$3.3k US$3.1k US$3.0k US$2.9k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$34b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 2.2%. We discount the terminal cash flows to today's value at a cost of equity of 6.2%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$5.3b× (1 + 2.2%) ÷ (6.2%– 2.2%) = US$135b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$135b÷ ( 1 + 6.2%)10= US$74b

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$108b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$448, the company appears quite undervalued at a 44% 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
NYSE:MCK Discounted Cash Flow October 30th 2023

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 McKesson 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 6.2%, which is based on a levered beta of 0.800. 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 McKesson

Strength
  • Earnings growth over the past year exceeded the industry.
  • Debt is well covered by earnings and cashflows.
Weakness
  • Dividend is low compared to the top 25% of dividend payers in the Healthcare market.
Opportunity
  • Annual earnings are forecast to grow for the next 3 years.
  • Good value based on P/E ratio and estimated fair value.
Threat
  • Total liabilities exceed total assets, which raises the risk of financial distress.
  • Annual earnings are forecast to grow slower than the American market.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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. What is the reason for the share price sitting below the intrinsic value? For McKesson, we've compiled three additional factors you should assess:

  1. Risks: For example, we've discovered 1 warning sign for McKesson that you should be aware of before investing here.
  2. Future Earnings: How does MCK'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.

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