An Intrinsic Calculation For SMART Global Holdings, Inc. (NASDAQ:SGH) Suggests It's 38% Undervalued

Key Insights

• SMART Global Holdings' estimated fair value is US$26.6 based on 2 Stage Free Cash Flow to Equity
• Current share price of US$16.6 suggests SMART Global Holdings is 38% undervalued
• Analyst price target for SGH is US$24.50 which is 7.9% below our fair value estimate

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of SMART Global Holdings, Inc. (NASDAQ:SGH) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Believe it or not, it's not too difficult to follow, as you'll see from our example!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

View our latest analysis for SMART Global Holdings

Is SMART Global Holdings Fairly Valued?

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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) forecast

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	US$37.2m	US$119.1m	US$140.2m	US$158.4m	US$173.8m	US$186.6m	US$197.4m	US$206.5m	US$214.4m	US$221.4m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ 17.72%	Est @ 13.00%	Est @ 9.69%	Est @ 7.38%	Est @ 5.76%	Est @ 4.63%	Est @ 3.83%	Est @ 3.28%
Present Value ($, Millions) Discounted @ 14%	US$32.7	US$92.1	US$95.4	US$94.8	US$91.4	US$86.3	US$80.3	US$73.9	US$67.5	US$61.3

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$776m

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 14%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$221m× (1 + 2.0%) ÷ (14%– 2.0%) = US$1.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$1.9b÷ ( 1 + 14%)¹⁰= US$533m

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$1.3b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of US$16.6, the company appears quite good value at a 38% 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.

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Global Holdings 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 14%, which is based on a levered beta of 1.951. 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 SMART Global Holdings

Looking Ahead:

Although the valuation of a company is important, it is only one of many factors that you need to assess for 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. What is the reason for the share price sitting below the intrinsic value? For SMART Global Holdings, there are three important aspects you should consider:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with SMART Global Holdings (at least 2 which are concerning) , and understanding them should be part of your investment process.
2. Future Earnings: How does SGH'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 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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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.