Is Smiths Group plc (LON:SMIN) Trading At A 34% Discount?

Key Insights

• The projected fair value for Smiths Group is UK£26.21 based on 2 Stage Free Cash Flow to Equity

• Smiths Group is estimated to be 34% undervalued based on current share price of UK£17.22

• The UK£19.93 analyst price target for SMIN is 24% less than our estimate of fair value

How far off is Smiths Group plc (LON:SMIN) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by estimating the company's future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

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.

Check out our latest analysis for Smiths Group

Is Smiths Group 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. 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (£, Millions)	UK£323.7m	UK£360.1m	UK£409.8m	UK£445.0m	UK£479.0m	UK£504.2m	UK£525.4m	UK£543.7m	UK£559.9m	UK£574.5m
Growth Rate Estimate Source	Analyst x5	Analyst x5	Analyst x5	Analyst x1	Analyst x1	Est @ 5.26%	Est @ 4.21%	Est @ 3.48%	Est @ 2.97%	Est @ 2.61%
Present Value (£, Millions) Discounted @ 6.9%	UK£303	UK£315	UK£335	UK£340	UK£343	UK£337	UK£329	UK£318	UK£307	UK£294

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£3.2b

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 1.8%. We discount the terminal cash flows to today's value at a cost of equity of 6.9%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£574m× (1 + 1.8%) ÷ (6.9%– 1.8%) = UK£11b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£11b÷ ( 1 + 6.9%)¹⁰= UK£5.8b

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£9.0b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK£17.2, the company appears quite undervalued at a 34% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf

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 6.9%, which is based on a levered beta of 0.940. 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 not viewed as a risk.

• Dividends are covered by earnings and cash flows.

Weakness

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

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

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. 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. Can we work out why the company is trading at a discount to intrinsic value? For Smiths Group, there are three further factors 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. Future Earnings: How does SMIN'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. 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.