Does STERIS plc (NYSE:STE) Look Attractive Based On These Two Valuation Methods?
With so many different financial models generating different conclusions, choosing the most relevant one to value a company can be daunting. A prime example of conflicts between valuation models is STERIS plc’s (NYSE:STE). While my discounted cash flow (DCF) model tells me that it is undervalued by 33.65%, my relative valuation model says it is overvalued by 27.26%. So, which model is more reliable and why?
Check out our latest analysis for STERIS
A closer look at intrinsic valuation
Forecasting anything into the distant future is difficult and the same applies to forecasting free cash flows (FCFs) for businesses. This is why I’ve decided to use analyst FCF forecasts in my DCF to see what the consensus view is while also removing some subjectivity. If you’re unfamiliar with valuation, the assumption behind every DCF is that a firm’s true value is derived from the sum of all its future FCFs, which is why quality forecasts are important. After discounting the sum of STE’s future FCFs by 10.0%, it’s equity value comes to $US$7.0b, then 84.62k shares outstanding are divided through. This results in an intrinsic value of $83.25. Take a look at how I arrived at this intrinsic value here.,
But is this value reliable? A key assumption in DCFs is that by the final year of our forecast horizon, which is year 5 in STE’s case, a company is assumed to be mature and therefore FCF should be growing at a sustainable rate. Given STE’s final year growth is at a sustainable 2.53%, we can rest assured that the assumptions we have made regarding an appropriate forecast horizon for STE are reasonable, and therefore our conclusions are significantly more dependable.
Deep-dive into relative valuation
The basic principle of relative valuation is that two companies with near identical characteristics should be priced similarly. But a big issue here is actually finding companies that are similar to STE, so I’ve used the Medical Equipment industry as a proxy. Obtaining the fair value of STE through relative valuation is quite straightforward. We simply multiply STE’s earnings by the industry’s P/E ratio, which gives us a share price of $80.93 that implies STE is currently overvalued. However, is this conclusion robust enough for us to use?
One quick way of finding out is to see if STE shares a similar capital structure to the overall Medical Equipment industry we are comparing it to. This is especially important since we are using the P/E ratio, which is ineffective when comparing two entities with dramatically differing capital structures. At 42.59, STE’s D/E ratio is significantly higher than the average firm in the Medical Equipment industry, which has a D/E ratio of 55.73%. In this case, rather than using a price multiple like P/E, we could resolve this issue by using an enterprise multiple like EV/EBITDA, which is immune from being influenced by differing capital structures.
Which Model Is Superior?
Unfortunately, both models have their own merits and deficiencies, which means the truth lies somewhere in the middle. Relative valuation is computationally simple but exposed to market irrationality, which undermines its usefulness. Conversely, intrinsic valuation is immune from these factors but heavily affected by human forecasting errors. Ultimately, investors should derive their final valuation based off both models. I encourage you to weight each model depending on your preferences to calculate a weighted average target price.
Next Steps:
For STE, I’ve compiled three essential factors you should further examine:
Financial Health: Does STE have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
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.
Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of STE? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. The Simply Wall St app conducts a discounted cash flow for every stock on the NYSE every 6 hours. If you want to find the calculation for other stocks just search here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at editorial-team@simplywallst.com.
