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- LSE:SMDS
DS Smith Plc's (LON:SMDS) Intrinsic Value Is Potentially 98% Above Its Share Price
Key Insights
- DS Smith's estimated fair value is UK£5.83 based on 2 Stage Free Cash Flow to Equity
- Current share price of UK£2.95 suggests DS Smith is potentially 49% undervalued
- The UK£3.56 analyst price target for SMDS is 39% less than our estimate of fair value
In this article we are going to estimate the intrinsic value of DS Smith Plc (LON:SMDS) by projecting its future cash flows and then discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
See our latest analysis for DS Smith
Step By Step Through The Calculation
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. To start off with, we need to estimate 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.
Generally we assume that a dollar today is more valuable than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) estimate
2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | 2033 | |
Levered FCF (£, Millions) | UK£130.2m | UK£300.3m | UK£346.3m | UK£434.0m | UK£467.5m | UK£491.8m | UK£511.7m | UK£528.3m | UK£542.5m | UK£554.9m |
Growth Rate Estimate Source | Analyst x6 | Analyst x6 | Analyst x4 | Analyst x2 | Analyst x2 | Est @ 5.19% | Est @ 4.05% | Est @ 3.25% | Est @ 2.69% | Est @ 2.29% |
Present Value (£, Millions) Discounted @ 6.9% | UK£122 | UK£263 | UK£283 | UK£332 | UK£334 | UK£329 | UK£320 | UK£309 | UK£296 | UK£283 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£2.9b
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 1.4%. We discount the terminal cash flows to today's value at a cost of equity of 6.9%.
Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = UK£555m× (1 + 1.4%) ÷ (6.9%– 1.4%) = UK£10b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£10b÷ ( 1 + 6.9%)10= UK£5.2b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is UK£8.0b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK£3.0, the company appears quite good value at a 49% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
Important Assumptions
We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the assumptions. 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 DS Smith 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 6.9%, which is based on a levered beta of 0.942. 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.
SWOT Analysis for DS Smith
- Earnings growth over the past year exceeded the industry.
- Debt is not viewed as a risk.
- Dividends are covered by earnings and cash flows.
- Dividend is low compared to the top 25% of dividend payers in the Packaging market.
- Good value based on P/E ratio and estimated fair value.
- Annual earnings are forecast to decline for the next 3 years.
Next Steps:
Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Instead the best use for 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 significantly impact the valuation. Why is the intrinsic value higher than the current share price? For DS Smith, we've compiled three fundamental items you should look at:
- Risks: For instance, we've identified 2 warning signs for DS Smith (1 can't be ignored) you should be aware of.
- Future Earnings: How does SMDS'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 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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Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an 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 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.
About LSE:SMDS
DS Smith
Provides packaging solutions, paper products, and recycling services worldwide.
Good value second-rate dividend payer.