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Is There An Opportunity With SMART Global Holdings, Inc.'s (NASDAQ:SGH) 27% Undervaluation?

Today we will run through one way of estimating the intrinsic value of SMART Global Holdings, Inc. (NASDAQ:SGH) by taking the forecast future cash flows of the company and discounting them back to today's value. This will be done using the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

View our latest analysis for SMART Global Holdings

Crunching the numbers

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. To begin with, we have to get estimates of the next ten years of cash flows. 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

2021

2022

2023

2024

2025

2026

2027

2028

2029

2030

Levered FCF ($, Millions)

US$79.1m

US$84.8m

US$89.7m

US$93.8m

US$97.4m

US$100.6m

US$103.5m

US$106.3m

US$108.9m

US$111.4m

Growth Rate Estimate Source

Analyst x1

Est @ 7.26%

Est @ 5.69%

Est @ 4.6%

Est @ 3.83%

Est @ 3.29%

Est @ 2.92%

Est @ 2.65%

Est @ 2.47%

Est @ 2.34%

Present Value ($, Millions) Discounted @ 8.8%

US$72.7

US$71.6

US$69.6

US$66.9

US$63.8

US$60.5

US$57.3

US$54.0

US$50.8

US$47.8

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$614m

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 (2.0%) 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 8.8%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$111m× (1 + 2.0%) ÷ (8.8%– 2.0%) = US$1.7b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$1.7b÷ ( 1 + 8.8%)10= US$718m

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$1.3b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of US$39.2, the company appears a touch undervalued at a 27% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

dcf
dcf

Important assumptions

Now 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 SMART Global Holdings 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 8.8%, which is based on a levered beta of 1.298. 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.

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and 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. What is the reason for the share price sitting below the intrinsic value? For SMART Global Holdings, there are three important items you should look at:

  1. Risks: For example, we've discovered 5 warning signs for SMART Global Holdings that you should be aware of before investing here.

  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for SGH'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 American stock every day, so if you want to find the intrinsic value of any other stock just search here.

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. 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.

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

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