Estimating The Fair Value Of Somero Enterprises, Inc. (LON:SOM)
Key Insights
Somero Enterprises' estimated fair value is UK£3.38 based on 2 Stage Free Cash Flow to Equity
Current share price of UK£3.00 suggests Somero Enterprises is potentially trading close to its fair value
How far off is Somero Enterprises, Inc. (LON:SOM) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced 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. Believe it or not, it's not too difficult to follow, as you'll see from our example!
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.
View our latest analysis for Somero Enterprises
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. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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 need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) estimate
2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | 2033 | |
Levered FCF ($, Millions) | US$16.2m | US$14.6m | US$13.6m | US$13.1m | US$12.8m | US$12.6m | US$12.5m | US$12.5m | US$12.6m | US$12.7m |
Growth Rate Estimate Source | Est @ -14.63% | Est @ -9.82% | Est @ -6.46% | Est @ -4.11% | Est @ -2.46% | Est @ -1.31% | Est @ -0.50% | Est @ 0.06% | Est @ 0.46% | Est @ 0.73% |
Present Value ($, Millions) Discounted @ 6.4% | US$15.2 | US$12.9 | US$11.3 | US$10.2 | US$9.3 | US$8.7 | US$8.1 | US$7.6 | US$7.2 | US$6.8 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$97m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 1.4%. We discount the terminal cash flows to today's value at a cost of equity of 6.4%.
Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$13m× (1 + 1.4%) ÷ (6.4%– 1.4%) = US$254m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$254m÷ ( 1 + 6.4%)10= US$136m
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$233m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK£3.0, the company appears about fair value at a 11% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.
Important Assumptions
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. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Somero Enterprises 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 6.4%, which is based on a levered beta of 1.013. 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 Somero Enterprises
Strength
Currently debt free.
Dividend is in the top 25% of dividend payers in the market.
Weakness
Earnings declined over the past year.
Opportunity
Current share price is below our estimate of fair value.
Threat
Dividends are not covered by cash flow.
Next Steps:
Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Somero Enterprises, we've compiled three relevant elements you should look at:
Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Somero Enterprises , and understanding it should be part of your investment process.
Future Earnings: How does SOM'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 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 AIM 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.
