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Deciding if you should use a relative valuation model over an intrinsic valuation model can be a difficult choice for many investors. For instance, while my relative valuation model tells me Hill-Rom Holdings, Inc.’s ( NYSE:HRC ) is overvalued by 38.45%, my discounted cash flow (DCF) model signals a 16.62% undervaluation instead. Which model do I listen to and more importantly why?
Examining intrinsic valuation
At the heart of the DCF is the basic assumption that a firm’s intrinsic valuation is equivalent to the sum of all its future free cash flows (FCF). As those familiar with the DCF will know, forecasting FCFs reliably past 5 years is often a difficult and subjective task, which is why I’ve used analyst FCF forecasts as a starting point for my model. Calculating the per share intrinsic value of HRC involves two key steps. First, I discount the sum of HRC’s future FCFs at 11%, which gives us an equity value of $US$5.9b, then 66.66k shares outstanding are divided through. This results in an intrinsic value of $88.25 . Take a look at how I arrived at this intrinsic value here. ,
But how accurate is this figure? A key assumption in DCFs is that by the final year of our forecast horizon, which is year 5 in HRC’s case, a company is assumed to be mature and therefore FCF should be growing at a sustainable rate. Given HRC’s final year growth is at a sustainable 1.69%, we can rest assured that the assumptions we have made regarding an appropriate forecast horizon for HRC are reasonable, and therefore our conclusions are significantly more dependable.
Examining relative valuation
While DCF models sum up future FCFs, relative valuation models are based on the idea that investors should pay the same price for two companies with identical risk and return profiles. Since the biggest dilemma is finding companies that are similar to HRC, a viable proxy would be the overall Medical Equipment industry itself. Obtaining the fair value of HRC through relative valuation is quite straightforward. We simply multiply HRC’s earnings by the industry’s P/E ratio, which gives us a share price of $142.48 that implies HRC is currently undervalued. However, is this conclusion robust enough for us to use?
One quick way of finding out is to see if HRC shares a similar growth profile to the overall Medical Equipment industry we are comparing it to. With a projected earnings growth rate of 20.59% for next year, HRC has a similar growth profile when compared with the Medical Equipment industry, which is projected to grow at 22.01%. This demonstrates that the Medical Equipment industry is a good proxy for HRC and ideal for our relative valuation.
Which Model Is Superior?
Unfortunately, both models have their own merits and deficiencies, which means the truth lies somewhere in the middle. Relative valuation is straightforward but prone to overall market mispricing. Meanwhile, intrinsic valuation is independent from market tendencies; however, is highly exposed to human error. Ultimately, investors should derive their final valuation based off both models. I encourage you to weight each model depending on your preferences to calculate a weighted average target price.
For HRC, I’ve compiled three essential aspects you should further examine:
- Financial Health : Does HRC 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 HRC’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 HRC? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. The Simply Wall St app conducts a discounted cash flow for every stock on the NYSE every 6 hours. If you want to find the calculation for other stocks just search here .
To help readers see past 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. For errors that warrant correction please contact the editor at email@example.com .