Is Smith & Nephew plc (LON:SN.) Trading At A 40% Discount?

Key Insights

• Smith & Nephew's estimated fair value is UK£17.05 based on 2 Stage Free Cash Flow to Equity

• Smith & Nephew's UK£10.21 share price signals that it might be 40% undervalued

• The US$12.68 analyst price target for SN. is 26% less than our estimate of fair value

Does the November 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 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.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. 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 Smith & Nephew

Is Smith & Nephew Fairly Valued?

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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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 ($, Millions)	US$606.3m	US$845.8m	US$939.0m	US$1.06b	US$1.14b	US$1.21b	US$1.27b	US$1.32b	US$1.36b	US$1.39b
Growth Rate Estimate Source	Analyst x6	Analyst x5	Analyst x1	Analyst x1	Est @ 8.07%	Est @ 6.11%	Est @ 4.73%	Est @ 3.77%	Est @ 3.09%	Est @ 2.62%
Present Value ($, Millions) Discounted @ 7.5%	US$564	US$732	US$757	US$792	US$797	US$787	US$767	US$740	US$710	US$678

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$7.3b

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 (1.5%) 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 7.5%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$1.4b× (1 + 1.5%) ÷ (7.5%– 1.5%) = US$24b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$24b÷ ( 1 + 7.5%)¹⁰= US$12b

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 US$19b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK£10.2, the company appears quite undervalued at a 40% 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

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 7.5%, which is based on a levered beta of 1.006. 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 Smith & Nephew

Strength

• Debt is well covered by earnings.

Weakness

• Earnings declined over the past year.

• Dividend is low compared to the top 25% of dividend payers in the Medical Equipment 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.

Next Steps:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or 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 Smith & Nephew, we've put together three pertinent factors you should further research:

1. Risks: For example, we've discovered 4 warning signs for Smith & Nephew (2 make us uncomfortable!) that you should be aware of before investing here.

2. 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.

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 LSE every day. If you want to find the calculation for other stocks 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.