Calculating The Intrinsic Value Of SThree plc (LON:STEM)

Key Insights

• The projected fair value for SThree is UK£3.17 based on 2 Stage Free Cash Flow to Equity

• Current share price of UK£3.59 suggests SThree is potentially trading close to its fair value

• The UK£5.77 analyst price target for STEM is 82% more than our estimate of fair value

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of SThree plc (LON:STEM) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

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.

Check out our latest analysis for SThree

What's The Estimated Valuation?

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 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.

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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (£, Millions)	UK£31.5m	UK£39.6m	UK£32.2m	UK£28.1m	UK£25.8m	UK£24.3m	UK£23.5m	UK£23.0m	UK£22.8m	UK£22.7m
Growth Rate Estimate Source	Analyst x3	Analyst x3	Est @ -18.69%	Est @ -12.67%	Est @ -8.45%	Est @ -5.50%	Est @ -3.44%	Est @ -1.99%	Est @ -0.98%	Est @ -0.27%
Present Value (£, Millions) Discounted @ 6.8%	UK£29.5	UK£34.7	UK£26.4	UK£21.6	UK£18.5	UK£16.4	UK£14.8	UK£13.6	UK£12.6	UK£11.8

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£200m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (1.4%) 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 6.8%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£23m× (1 + 1.4%) ÷ (6.8%– 1.4%) = UK£426m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£426m÷ ( 1 + 6.8%)¹⁰= UK£221m

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£421m. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of UK£3.6, 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.

dcf

The Assumptions

Now 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 SThree 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 6.8%, which is based on a levered beta of 0.916. 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 SThree

Strength

• Debt is not viewed as a risk.

• Dividends are covered by earnings and cash flows.

Weakness

• Earnings declined over the past year.

• Dividend is low compared to the top 25% of dividend payers in the Professional Services market.

Opportunity

• Annual earnings are forecast to grow faster than the British market.

• Good value based on P/E ratio compared to estimated Fair P/E ratio.

Threat

• Revenue is forecast to grow slower than 20% per year.

Moving On:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For SThree, we've compiled three essential aspects you should explore:

1. Risks: Every company has them, and we've spotted 1 warning sign for SThree you should know about.

2. Future Earnings: How does STEM'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the LSE every day. If you want to find the calculation for other stocks 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.