Is There An Opportunity With Stelrad Group PLC's (LON:SRAD) 44% Undervaluation?

Key Insights

• The projected fair value for Stelrad Group is UK£2.23 based on 2 Stage Free Cash Flow to Equity

• Stelrad Group's UK£1.25 share price signals that it might be 44% undervalued

• Analyst price target for SRAD is UK£1.83 which is 18% below our fair value estimate

Today we will run through one way of estimating the intrinsic value of Stelrad Group PLC (LON:SRAD) by taking the expected future cash flows and discounting them to today's value. This will be 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. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Check out our latest analysis for Stelrad Group

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. To start off with, we need to estimate 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 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)	UK£22.2m	UK£25.8m	UK£28.3m	UK£30.4m	UK£32.1m	UK£33.4m	UK£34.6m	UK£35.5m	UK£36.3m	UK£37.0m
Growth Rate Estimate Source	Analyst x3	Analyst x3	Est @ 9.95%	Est @ 7.34%	Est @ 5.51%	Est @ 4.23%	Est @ 3.33%	Est @ 2.70%	Est @ 2.27%	Est @ 1.96%
Present Value (£, Millions) Discounted @ 12%	UK£19.8	UK£20.6	UK£20.2	UK£19.4	UK£18.3	UK£17.0	UK£15.7	UK£14.4	UK£13.2	UK£12.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£171m

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 1.2%. We discount the terminal cash flows to today's value at a cost of equity of 12%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£37m× (1 + 1.2%) ÷ (12%– 1.2%) = UK£351m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£351m÷ ( 1 + 12%)¹⁰= UK£114m

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 UK£284m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of UK£1.3, the company appears quite undervalued at a 44% 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.

dcf

The 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 Stelrad Group 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 12%, which is based on a levered beta of 1.533. 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 Stelrad Group

Strength

• Debt is well covered by earnings and cashflows.

• Dividend is in the top 25% of dividend payers in the market.

Weakness

• Earnings declined over the past year.

Opportunity

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

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

Threat

• Dividends are not covered by earnings.

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

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. It's not possible to obtain a foolproof valuation with a DCF model. 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. Can we work out why the company is trading at a discount to intrinsic value? For Stelrad Group, there are three essential items you should further research:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Stelrad Group , and understanding them should be part of your investment process.

2. Future Earnings: How does SRAD'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 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 LSE 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.

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