Does the December share price for Smith & Nephew plc (LON:SN.) reflect itâs really worth? Today, I will calculate the stockâs intrinsic value by taking the foreast future cash flows of the company and discounting them back to todayâs value. This is done using the Discounted Cash Flows (DCF) model. It may sound complicated, but actually it is quite simple! If you want to learn more about discounted cash flow, the basis for my calcs can be read in detail in the Simply Wall St analysis model. If you are reading this and its not December 2018 then I highly recommend you check out the latest calculation for Smith & Nephew by following the link below.
See our latest analysis for Smith & Nephew
Iâm using the 2-stage growth model, which simply means we take in account two stages of companyâs growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have perpetual stable growth rate. To start off with we need to estimate the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount this to its value today and sum up the total to get the present value of these cash flows.
2019 | 2020 | 2021 | 2022 | 2023 | |
Levered FCF ($, Millions) | $823.56 | $893.71 | $886.00 | $989.00 | $1.01k |
Source | Analyst x9 | Analyst x7 | Analyst x1 | Analyst x1 | Est @ 2.06% |
Present Value Discounted @ 8.28% | $760.58 | $762.27 | $697.90 | $719.47 | $678.13 |
Present Value of 5-year Cash Flow (PVCF)= US$3.6b
After calculating the present value of future cash flows in the intial 5-year period we need to calculate the Terminal Value, which accounts for all the future cash flows beyond the first stage. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 1.4%. We discount this to todayâs value at a cost of equity of 8.3%.
Terminal Value (TV) = FCF2022 à (1 + g) ÷ (r â g) = US$1.0b à (1 + 1.4%) ÷ (8.3% â 1.4%) = US$15b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = US$15b ÷ ( 1 + 8.3%)5 = US$10.0b
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is US$14b. To get the intrinsic value per share, we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR. This results in an intrinsic value of £12.22. Compared to the current share price of £14.35, the stock is fair value, maybe slightly overvalued at the time of writing.
Iâd like to 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 donât agree with my result, have a go at the calculation yourself and play with the assumptions. Because 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 weighed average cost of capital, WACC) which accounts for debt. In this calculation Iâve used 8.3%, which is based on a levered beta of 0.800. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Whilst important, DCF calculation shouldnât be the only metric you look at when researching a company. For SN., Iâve compiled three relevant factors you should look at:
PS. The Simply Wall St app conducts a discounted cash flow for every stock on the LON every 6 hours. If you want to find the calculation for other stocks just search here.
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