Stock Analysis

Calculating The Intrinsic Value Of STERIS plc (NYSE:STE)

NYSE:STE
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Key Insights

  • STERIS' estimated fair value is US$193 based on 2 Stage Free Cash Flow to Equity
  • Current share price of US$183 suggests STERIS is trading close to its fair value
  • Analyst price target for STE is US$221 which is 15% above our fair value estimate

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of STERIS plc (NYSE:STE) as an investment opportunity 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. There's really not all that much to it, even though it might appear quite complex.

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.

Check out our latest analysis for STERIS

The Method

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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

2023 2024 2025 2026 2027 2028 2029 2030 2031 2032
Levered FCF ($, Millions) US$820.0m US$942.5m US$1.07b US$1.17b US$1.28b US$1.35b US$1.42b US$1.48b US$1.53b US$1.57b
Growth Rate Estimate Source Analyst x1 Analyst x1 Analyst x1 Analyst x1 Analyst x1 Est @ 6.19% Est @ 4.92% Est @ 4.04% Est @ 3.42% Est @ 2.99%
Present Value ($, Millions) Discounted @ 8.4% US$757 US$803 US$841 US$848 US$853 US$836 US$810 US$777 US$742 US$705

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$8.0b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (2.0%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 8.4%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$1.6b× (1 + 2.0%) ÷ (8.4%– 2.0%) = US$25b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$25b÷ ( 1 + 8.4%)10= US$11b

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$19b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$183, the company appears about fair value at a 4.9% 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.

dcf
NYSE:STE Discounted Cash Flow December 28th 2022

Important Assumptions

Now 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 STERIS 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 8.4%, which is based on a levered beta of 0.980. 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 STERIS

Strength
  • Debt is well covered by earnings and cashflows.
Weakness
  • Dividend is low compared to the top 25% of dividend payers in the Medical Equipment market.
Opportunity
  • Expected to breakeven next year.
  • Has sufficient cash runway for more than 3 years based on current free cash flows.
  • Current share price is below our estimate of fair value.
Threat
  • Paying a dividend but company is unprofitable.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it 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. For STERIS, we've put together three relevant items you should consider:

  1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with STERIS , and understanding these should be part of your investment process.
  2. Future Earnings: How does STE'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.
  3. Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

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.

Valuation is complex, but we're helping make it simple.

Find out whether STERIS is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.

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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.