A Look At The Fair Value Of Step One Clothing Limited (ASX:STP)

Key Insights

• The projected fair value for Step One Clothing is AU$1.37 based on 2 Stage Free Cash Flow to Equity

• Current share price of AU$1.14 suggests Step One Clothing is potentially trading close to its fair value

• Step One Clothing's peers seem to be trading at a lower discount to fair value based onthe industry average of 15%

Does the January share price for Step One Clothing Limited (ASX:STP) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by projecting its future cash flows and then discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. There's really not all that much to it, even though it might appear quite complex.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

See our latest analysis for Step One Clothing

Crunching The Numbers

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. 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) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	AU$8.60m	AU$11.0m	AU$12.0m	AU$12.7m	AU$13.4m	AU$13.9m	AU$14.4m	AU$14.9m	AU$15.3m	AU$15.7m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Analyst x1	Est @ 6.23%	Est @ 4.98%	Est @ 4.11%	Est @ 3.50%	Est @ 3.08%	Est @ 2.78%	Est @ 2.57%
Present Value (A$, Millions) Discounted @ 7.1%	AU$8.0	AU$9.6	AU$9.8	AU$9.7	AU$9.5	AU$9.2	AU$8.9	AU$8.6	AU$8.3	AU$7.9

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$90m

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 (2.1%) 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 7.1%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$16m× (1 + 2.1%) ÷ (7.1%– 2.1%) = AU$321m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$321m÷ ( 1 + 7.1%)¹⁰= AU$162m

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 AU$252m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of AU$1.1, the company appears about fair value at a 17% 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.

ASX:STP Discounted Cash Flow January 16th 2024

The 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. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Step One Clothing 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 7.1%, which is based on a levered beta of 0.997. 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 Step One Clothing

Strength

• Currently debt free.

Weakness

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

Opportunity

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

• Current share price is below our estimate of fair value.

Threat

• Dividends are not covered by earnings and cashflows.

Next Steps:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Step One Clothing, we've compiled three relevant factors you should explore:

1. Risks: We feel that you should assess the 2 warning signs for Step One Clothing we've flagged before making an investment in the company.

2. Future Earnings: How does STP'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 High Quality Alternatives: Do you like a good all-rounder? 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 ASX every day. If you want to find the calculation for other stocks just search here.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.