Today we will run through one way of estimating the intrinsic value of Smart Sand, Inc. (NASDAQ:SND) by taking the expected future cash flows and discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. There's really not all that much to it, even though it might appear quite complex.
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
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 discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) estimate
|Levered FCF ($, Millions)||US$12.0m||US$11.7m||US$11.6m||US$11.5m||US$11.6m||US$11.7m||US$11.9m||US$12.0m||US$12.2m||US$12.5m|
|Growth Rate Estimate Source||Analyst x4||Analyst x3||Est @ -1.15%||Est @ -0.2%||Est @ 0.48%||Est @ 0.94%||Est @ 1.27%||Est @ 1.5%||Est @ 1.66%||Est @ 1.78%|
|Present Value ($, Millions) Discounted @ 13%||US$10.7||US$9.2||US$8.1||US$7.2||US$6.4||US$5.8||US$5.2||US$4.7||US$4.2||US$3.8|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$65m
The second stage is also known as Terminal Value, this is the business's cash flow after 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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 13%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$12m× (1 + 2.0%) ÷ (13%– 2.0%) = US$121m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$121m÷ ( 1 + 13%)10= US$37m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$102m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$2.0, the company appears about fair value at a 14% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
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. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Smart Sand 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 13%, which is based on a levered beta of 2.000. 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.
Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. 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. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For Smart Sand, there are three further aspects you should explore:
- Risks: Case in point, we've spotted 6 warning signs for Smart Sand you should be aware of, and 1 of them is concerning.
- Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for SND'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 American stock every day, so if you want to find the intrinsic value of any other stock just search here.
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Smart Sand, Inc., an integrated frac sand supply and services company, engages in the excavation, processing, and sale of sands or proppant for use in hydraulic fracturing operations in the oil and gas industry in the United States.
Moderate growth potential and slightly overvalued.