Does the August share price for Smith & Nephew plc (LON: SN.) Reflect its true value? Today we’re going to estimate the intrinsic value of the stock by taking the company’s future cash flow forecast and discounting it to today’s value. One way to do this is to use the Discounted Cash Flow (DCF) model. There really isn’t much to do, although it might seem quite complex.
There are many ways that businesses can be assessed, so we would like to point out that a DCF is not perfect for all situations. For those who are passionate about equity analysis, the Simply Wall St analysis template here may be something of interest to you.
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We use the 2-step growth model, which simply means that we take into account two stages of business growth. In the initial period, the business can have a higher growth rate, and the second stage is usually assumed to have a stable growth rate. To begin with, we need to estimate the next ten years of cash flow. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated value. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow down more in the early years than in subsequent years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, and therefore the sum of those future cash flows is then discounted to today’s value. :
10-year free cash flow (FCF) forecast
|Leverage FCF ($, Millions)||US $ 692.0 million||US $ 775.3 million||US $ 899.0 million||US $ 950.0 million||US $ 986.4 million||US $ 1.02 billion||1.04 billion US dollars||US $ 1.06 billion||US $ 1.08 billion||US $ 1.09 billion|
|Source of estimated growth rate||Analyst x5||Analyst x4||Analyst x1||Analyst x1||Est @ 3.83%||Est @ 2.96%||East @ 2.35%||Est @ 1.92%||Est @ 1.62%||Est @ 1.41%|
|Present value (in millions of dollars) discounted at 6.1%||US $ 652||$ 689||US $ 753||US $ 750||US $ 735||US $ 713||$ 688||US $ 661||US $ 633||US $ 605|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 6.9 billion
It is now a matter of calculating the Terminal Value, which takes into account all future cash flows after this ten-year period. For a number of reasons, a very conservative growth rate is used which cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (0.9%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to their present value, using a cost of equity of 6.1%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US $ 1.1 billion × (1 + 0.9%) ÷ (6.1% – 0.9%) = US $ 21 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= US $ 21 billion ÷ (1 + 6.1%)ten= US $ 12 billion
The total value is the sum of the cash flows for the next ten years plus the final present value, which gives the total value of equity, which in this case is US $ 19 billion. The last step is then to divide the equity value by the number of shares outstanding. Compared to the current share price of UK £ 14.3, the company appears to be roughly at fair value with a 9.1% discount to the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.
The above calculation is very dependent on two assumptions. One is the discount rate and the other is cash flow. Part of investing is coming up with your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Smith & Nephew 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 takes debt into account. . In this calculation, we used 6.1%, which is based on a leveraged beta of 0.970. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
To move on :
Valuation is only one side of the coin in terms of building your investment thesis, and ideally, it won’t be the only piece of analysis you look at for a business. DCF models are not the ultimate solution for investment valuation. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. For Smith & Nephew, we’ve put together three relevant things you should explore:
- Risks: For example, we discovered 2 warning signs for Smith & Nephew which you should know before investing here.
- Future benefits: How does the growth rate of SN. Does it compare with that of its peers and the wider market? Dig deeper into the analyst consensus number for years to come by interacting with our free analyst growth expectations chart.
- Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what you might be missing!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for every share on the LSE. If you want to find the calculation for other actions, just search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in the mentioned stocks.
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