Is there an opportunity with the 35% undervaluation of Simpson Manufacturing Co., Inc. (NYSE: SSD)?
Today we’re going to do a simple walkthrough of a valuation method used to estimate the attractiveness of Simpson Manufacturing Co., Inc. (NYSE:SSD) as an investment opportunity by projecting its future cash flows and then discounting them to the present value. Our analysis will use the discounted cash flow (DCF) model. Believe it or not, it’s not too hard to follow, as you’ll see in our example!
We draw your attention to the fact that there are many ways to value a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you want to know more about discounted cash flow, the rationale for this calculation can be read in detail in the Simply Wall St analysis template.
Check out our latest analysis for Simpson Manufacturing
Is Simpson Manufacturing Fairly Valued?
We use the 2-stage growth model, which simply means that we consider two stages of business growth. In the initial period, the company may have a higher growth rate, and the second stage is generally assumed to have a stable growth rate. To start, we need to estimate the cash flows for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported 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 more in early years than in later years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, and so the sum of these future cash flows is then discounted to today’s value:
Estimated free cash flow (FCF) over 10 years
|Leveraged FCF ($, millions)||$235.7 million||$275.1 million||$304.1 million||$328.2 million||$348.3 million||$365.3 million||$379.9 million||$392.6 million||$404.2 million||$414.8 million|
|Growth rate estimate Source||Analyst x3||Analyst x3||Is at 10.52%||Is at 7.94%||Is at 6.13%||Is at 4.87%||Is 3.98%||Is at 3.37%||Is at 2.93%||Is at 2.63%|
|Present value (in millions of dollars) discounted at 6.5%||$221||$243||$252||$256||$255||$251||$245||$238||$230||$222|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $2.4 billion
After calculating the present value of future cash flows over the initial 10-year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first stage. 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 (1.9%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 6.5%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$415 million × (1 + 1.9%) ÷ (6.5%–1.9%) = US$9.3 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= $9.3 billion ÷ (1 + 6.5%)ten= US$5.0 billion
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is $7.4 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current stock price of US$111, the company appears to have pretty good value at a 35% discount to the current stock price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in a different galaxy. Keep that in mind.
The above calculation is highly dependent on two assumptions. One is the discount rate and the other is the cash flows. 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 Simpson Manufacturing 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 6.5%, which is based on a leveraged beta of 1.069. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Let’s move on :
Although a business valuation is important, it is only one of many factors you need to assess for a business. The DCF model is not a perfect stock valuation tool. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on the valuation. Can we understand why the company is trading at a discount to its intrinsic value? For Simpson Manufacturing, there are three fundamental aspects that you must evaluate:
- Risks: To this end, you should inquire about the 3 warning signs we spotted with Simpson Manufacturing (including 1 that makes us a little uncomfortable).
- Management:Did insiders increase their shares to take advantage of market sentiment regarding SSD’s future prospects? View our management and board analysis with insights into CEO compensation and governance factors.
- Other strong companies: Low debt, high returns on equity and good past performance are essential to a strong business. Why not explore our interactive list of stocks with strong trading fundamentals to see if there are any other companies you may not have considered!
PS. Simply Wall St updates its DCF calculation for every US stock daily, so if you want to find the intrinsic value of any other stock, do a 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 only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.