Is There An Opportunity With Severn Trent PLC's (LON:SVT) 35% Undervaluation?

Key Insights

• The projected fair value for Severn Trent is UK£36.35 based on 2 Stage Free Cash Flow to Equity

• Current share price of UK£23.74 suggests Severn Trent is potentially 35% undervalued

• Our fair value estimate is 32% higher than Severn Trent's analyst price target of UK£27.45

Does the August share price for Severn Trent PLC (LON:SVT) 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. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

View our latest analysis for Severn Trent

The Model

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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (£, Millions)	-UK£142.8m	-UK£28.5m	UK£182.1m	UK£269.8m	UK£361.8m	UK£449.6m	UK£527.9m	UK£594.4m	UK£649.3m	UK£694.0m
Growth Rate Estimate Source	Analyst x3	Analyst x4	Analyst x3	Est @ 48.12%	Est @ 34.10%	Est @ 24.28%	Est @ 17.41%	Est @ 12.60%	Est @ 9.24%	Est @ 6.88%
Present Value (£, Millions) Discounted @ 6.7%	-UK£134	-UK£25.0	UK£150	UK£208	UK£262	UK£305	UK£336	UK£355	UK£364	UK£364

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£2.2b

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 6.7%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£694m× (1 + 1.4%) ÷ (6.7%– 1.4%) = UK£13b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£13b÷ ( 1 + 6.7%)¹⁰= UK£7.0b

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£9.2b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK£23.7, the company appears quite good value at a 35% 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.

dcf

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. 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 Severn Trent 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 6.7%, which is based on a levered beta of 0.893. 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 Severn Trent

Strength

• No major strengths identified for SVT.

Weakness

• Interest payments on debt are not well covered.

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

Opportunity

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

• Trading below our estimate of fair value by more than 20%.

Threat

• Debt is not well covered by operating cash flow.

• Dividends are not covered by earnings and cashflows.

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

Looking Ahead:

Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. 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. Can we work out why the company is trading at a discount to intrinsic value? For Severn Trent, we've compiled three further aspects you should further examine:

1. Risks: As an example, we've found 3 warning signs for Severn Trent (2 are a bit concerning!) that you need to consider before investing here.

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for SVT's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

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. Simply Wall St updates its DCF calculation for every British stock every day, so if you want to find the intrinsic value of any other stock 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.