Smiths Group plc (LON: SMIN) shares could be 47% lower than their estimate of intrinsic value
Today we’re going to go over one way to estimate the intrinsic value of Smiths Group plc (LON: SMIN) by projecting its future cash flows and then discounting them to today’s value. Our analysis will use the discounted cash flow (DCF) model. Believe it or not, it’s not too hard to follow, as you will see in our example!
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. If you still have burning questions about this type of valuation, take a look at the Simply Wall St.
See our latest analysis for Smiths Group
We use the 2-step growth model, which simply means that we take into account two stages of business growth. During 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, so we need to discount the sum of these future cash flows to arrive at an estimate of the present value:
10-year Free Cash Flow (FCF) estimate
|Leverage FCF (£, Million)||United Kingdom £ 358.3 million||United Kingdom £ 403.0 million||UK £ 486.5m||United Kingdom £ 532.0m||United Kingdom £ 564.1 million||United Kingdom £ 589.4 million||United Kingdom £ 609.5 million||United Kingdom £ 625.7 million||United Kingdom £ 639.0 million||United Kingdom £ 650.3million|
|Source of estimated growth rate||Analyst x3||Analyst x4||Analyst x2||Analyst x1||Est @ 6.03%||East @ 4.49%||East @ 3.41%||East @ 2.66%||Est @ 2.13%||East @ 1.76%|
|Present value (£, million) discounted at 6.0%||United Kingdom £ 338||United Kingdom £ 359||United Kingdom £ 409||United Kingdom £ 422||United Kingdom £ 422||United Kingdom £ 417||UK £ 407||United Kingdom £ 394||£ 380||United Kingdom £ 365|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = 3.9 billion pounds sterling in the United Kingdom
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 step. The Gordon growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 0.9%. We discount the terminal cash flows to their present value at a cost of equity of 6.0%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = UK £ 650m × (1 + 0.9%) ÷ (6.0% –0.9%) = UK £ 13b
Present value of terminal value (PVTV)= TV / (1 + r)ten= UK £ 13b ÷ (1 + 6.0%)ten= £ 7.3 billion in the UK
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total value of equity, which in this case is £ 11 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 £ 15.0, the company looks fairly good value with a 47% discount to the current share price. The assumptions in any calculation have a big impact on the valuation, so it’s best to take this as a rough estimate, not precise down to the last penny.
We draw your attention to the fact that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play around with them. 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 full picture of a company’s potential performance. Since we view Smiths Group 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 into account debt. In this calculation, we used 6.0%, which is based on a leveraged beta of 1.033. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our beta from the industry average beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
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. The DCF model is not a perfect stock assessment tool. 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. For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. Can we understand why the company trades at a discount to its intrinsic value? For Smiths Group, we’ve put together three fundamental things you should consider:
- Risks: For example, we have identified 2 warning signs for Smiths Group that you need to be aware of.
- Management: Have insiders increased their stocks to take advantage of market sentiment about SMIN’s future prospects? Check out our management and board analysis with information on CEO compensation and governance factors.
- 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 any stock 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 any of the stocks mentioned.