Today we’ll do a simple run through of a valuation method used to estimate the attractiveness of Smith & Nephew plc (LON:SN.) as an investment opportunity by estimating the company’s future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. It may sound complicated, but actually it is quite simple!
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.
What’s the estimated valuation?
We’re using the 2-stage growth model, which simply means we take in account two stages of company’s growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To begin with, we have to get estimates of 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.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today’s value:
10-year free cash flow (FCF) estimate
|Levered FCF ($, Millions)||US$857.1m||US$819.2m||US$884.7m||US$1.02b||US$1.07b||US$1.11b||US$1.14b||US$1.17b||US$1.19b||US$1.22b|
|Growth Rate Estimate Source||Analyst x7||Analyst x5||Analyst x3||Analyst x2||Est @ 4.73%||Est @ 3.68%||Est @ 2.94%||Est @ 2.42%||Est @ 2.06%||Est @ 1.81%|
|Present Value ($, Millions) Discounted @ 8.0%||US$794||US$703||US$703||US$752||US$729||US$700||US$668||US$633||US$599||US$565|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$6.8b
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 1.2%. We discount the terminal cash flows to today’s value at a cost of equity of 8.0%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$1.2b× (1 + 1.2%) ÷ (8.0%– 1.2%) = US$18b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$18b÷ ( 1 + 8.0%)10= US$8.5b
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$15b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£15.9, the company appears around fair value at the time of writing. Valuations are imprecise instruments though, rather like a telescope – move a few degrees and end up in a different galaxy. Do keep this in mind.
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don’t have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 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 accounts for debt. In this calculation we’ve used 8.0%, which is based on a levered beta of 0.975. 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.
Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. Preferably you’d apply different cases and assumptions and see how they would impact the company’s valuation. For example, changes in the company’s cost of equity or the risk free rate can significantly impact the valuation. For Smith & Nephew, we’ve put together three important elements you should further research:
- Risks: Case in point, we’ve spotted 3 warning signs for Smith & Nephew you should be aware of.
- Management:Have insiders been ramping up their shares to take advantage of the market’s sentiment for SN.’s future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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. Simply Wall St updates its DCF calculation for every British stock every day, so if you want to find the intrinsic value of any other stock just search here.
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This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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