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Does the June share price for Smith & Nephew plc (LON:SN.) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by estimating the company's future cash flows and discounting them to their present value. This is done using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.
Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
Step by step through the calculation
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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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) estimate
|Levered FCF ($, Millions)||$699.33||$820.14||$906.00||$972.47||$1.03k||$1.07k||$1.10k||$1.13k||$1.16k||$1.18k|
|Growth Rate Estimate Source||Analyst x6||Analyst x7||Analyst x5||Est @ 7.34%||Est @ 5.5%||Est @ 4.22%||Est @ 3.32%||Est @ 2.69%||Est @ 2.25%||Est @ 1.95%|
|Present Value ($, Millions) Discounted @ 7.45%||$650.85||$710.36||$730.32||$729.55||$716.33||$694.80||$668.12||$638.54||$607.67||$576.54|
Present Value of 10-year Cash Flow (PVCF)= $6.72b
"Est" = FCF growth rate estimated by Simply Wall St
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 10-year government bond rate of 1.2%. We discount the terminal cash flows to today's value at a cost of equity of 7.4%.
Terminal Value (TV) = FCF2029 × (1 + g) ÷ (r – g) = US$1.2b × (1 + 1.2%) ÷ (7.4% – 1.2%) = US$19b
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = $US$19b ÷ ( 1 + 7.4%)10 = $9.38b
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is $16.10b. The last step is to then divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate in the company’s reported currency of $18.44. However, SN.’s primary listing is in United Kingdom, and 1 share of SN. in USD represents 0.787 ( USD/ GBP) share of NYSE:SNN, so the intrinsic value per share in GBP is £14.51. Compared to the current share price of £17.05, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
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. 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 Smith & Nephew 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 7.4%, which is based on a levered beta of 0.936. 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.
Although the valuation of a company is important, it 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?" 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. For Smith & Nephew, There are three fundamental factors you should further examine:
- Financial Health: Does SN. 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 SN.'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 SN.? 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 valuation for every stock on the LON every day. If you want to find the calculation for other stocks just search here.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.