Estimating The Intrinsic Value Of Smiths Group plc (LON:SMIN)

Key Insights

• Smiths Group's estimated fair value is UK£15.44 based on 2 Stage Free Cash Flow to Equity

• With UK£16.44 share price, Smiths Group appears to be trading close to its estimated fair value

• The UK£18.63 analyst price target for SMIN is 21% more than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of Smiths Group plc (LON:SMIN) by projecting its future cash flows and then discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

Check out our latest analysis for Smiths Group

Step By Step Through The Calculation

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, 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

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (£, Millions)	UK£207.5m	UK£350.1m	UK£334.9m	UK£400.0m	UK£426.0m	UK£444.9m	UK£460.3m	UK£473.2m	UK£484.3m	UK£494.0m
Growth Rate Estimate Source	Analyst x5	Analyst x6	Analyst x5	Analyst x1	Analyst x1	Est @ 4.43%	Est @ 3.47%	Est @ 2.80%	Est @ 2.33%	Est @ 2.01%
Present Value (£, Millions) Discounted @ 8.8%	UK£191	UK£296	UK£260	UK£286	UK£280	UK£269	UK£256	UK£242	UK£228	UK£213

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£2.5b

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 1.2%. We discount the terminal cash flows to today's value at a cost of equity of 8.8%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = UK£494m× (1 + 1.2%) ÷ (8.8%– 1.2%) = UK£6.7b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£6.7b÷ ( 1 + 8.8%)¹⁰= UK£2.9b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is UK£5.4b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of UK£16.4, the company appears around fair value at the time of writing. 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

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 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 8.8%, which is based on a levered beta of 1.078. 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

• Debt is well covered by earnings.

Weakness

• Dividend is low compared to the top 25% of dividend payers in the Industrials market.

• Expensive based on P/S ratio and estimated fair value.

Opportunity

• Expected to breakeven next year.

• Has sufficient cash runway for more than 3 years based on current free cash flows.

Threat

• Debt is not well covered by operating cash flow.

• Dividends are not covered by cash flow.

Moving On:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Smiths Group, we've compiled three further items you should assess:

1. Risks: We feel that you should assess the 1 warning sign for Smiths Group we've flagged before making an investment in the company.

2. 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.

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.

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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