Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Smiths Group plc (LON:SMIN) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
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 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, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) forecast
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
Levered FCF (£, Millions)
UK£281.3m
UK£340.3m
UK£394.3m
UK£418.4m
UK£439.0m
UK£456.8m
UK£472.7m
UK£487.2m
UK£500.8m
UK£513.7m
Growth Rate Estimate Source
Analyst x4
Analyst x4
Analyst x3
Est @ 6.11%
Est @ 4.91%
Est @ 4.07%
Est @ 3.48%
Est @ 3.07%
Est @ 2.78%
Est @ 2.58%
Present Value (£, Millions) Discounted @ 6.8%
UK£263
UK£298
UK£324
UK£322
UK£316
UK£308
UK£299
UK£288
UK£277
UK£266
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = UK£3.0b
The second stage is also known as Terminal Value, this is the business's cash flow after 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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 6.8%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£11b÷ ( 1 + 6.8%)10= UK£5.8b
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£8.8b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of UK£17.7, the company appears quite good value at a 31% 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.
LSE:SMIN Discounted Cash Flow January 10th 2025
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 Smiths 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 6.8%, which is based on a levered beta of 0.964. 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 Smiths Group
Strength
Earnings growth over the past year exceeded the industry.
Debt is not viewed as a risk.
Dividends are covered by earnings and cash flows.
Weakness
Earnings growth over the past year is below its 5-year average.
Dividend is low compared to the top 25% of dividend payers in the Industrials market.
Opportunity
Annual revenue is forecast to grow faster than the British market.
Trading below our estimate of fair value by more than 20%.
Significant insider buying over the past 3 months.
Threat
Annual earnings are forecast to grow slower than the British market.
Next Steps:
Whilst important, the DCF calculation 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. 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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Why is the intrinsic value higher than the current share price? For Smiths Group, we've compiled three pertinent aspects you should consider:
Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for SMIN's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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.
