An Intrinsic Calculation For Smith & Nephew plc (LON:SN.) Suggests It's 34% Undervalued

Key Insights

• Smith & Nephew's estimated fair value is UK£15.04 based on 2 Stage Free Cash Flow to Equity

• Current share price of UK£9.98 suggests Smith & Nephew is potentially 34% undervalued

• Analyst price target for SN. is US$13.04 which is 13% below our fair value estimate

Today we will run through one way of estimating the intrinsic value of Smith & Nephew plc (LON:SN.) by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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 Smith & Nephew

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. 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) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	US$567.4m	US$716.7m	US$781.3m	US$1.01b	US$1.04b	US$1.07b	US$1.10b	US$1.12b	US$1.15b	US$1.17b
Growth Rate Estimate Source	Analyst x9	Analyst x9	Analyst x8	Analyst x3	Analyst x2	Est @ 2.85%	Est @ 2.53%	Est @ 2.30%	Est @ 2.14%	Est @ 2.03%
Present Value ($, Millions) Discounted @ 7.5%	US$528	US$620	US$628	US$752	US$725	US$693	US$661	US$629	US$597	US$567

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$6.4b

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 (1.8%) 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$1.2b× (1 + 1.8%) ÷ (7.5%– 1.8%) = US$21b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$21b÷ ( 1 + 7.5%)¹⁰= US$10b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$16b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of UK£10.0, the company appears quite undervalued at a 34% 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 1.052. 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

• Earnings growth over the past year exceeded the industry.

• Debt is well covered by earnings and cashflows.

Weakness

• 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.

• Good value based on P/E ratio and estimated fair value.

Threat

• Dividends are not covered by earnings and cashflows.

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

Moving On:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For Smith & Nephew, there are three essential items you should further research:

1. Risks: You should be aware of the 3 warning signs for Smith & Nephew (1 is a bit concerning!) we've uncovered before considering an investment in the company.

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 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. 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.