How far is Synthomer plc (LON:SYNT) from intrinsic value? Using the latest financial data, we will look at whether the stock is fairly valued by estimating the company’s future cash flows and discounting them to present value. The discounted cash flow (DCF) model is the tool we will use for this. It may sound complicated, but it’s actually quite simple!
However, remember that there are many ways to estimate the value of a business and a DCF is just one method. If you still have burning questions about this type of assessment, take a look at Simply Wall St’s analytics model.
Check out our latest analysis for Synthomer
What is the estimated value?
We use what is called a 2-stage model, which simply means that we have two different growth rates for the company’s cash flows. In general, the first stage is higher growth and the second stage is lower growth phase. In the first phase, we need to estimate the cash flows for the company over the next ten years. Where possible we use analyst estimates, but when these are not available we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We expect companies with declining free cash flow to slow their rate of contraction and companies with growing free cash flow to slow their growth rate over this period. We do this to take into account that growth tends to slow down more in the early years than in later years.
In general, we assume a dollar is worth more today than a dollar will be in the future, so we discount the value of those future cash flows to their estimated value in today’s dollars:
10-year free cash flow (FCF) forecast.
|Leveraged FCF (£, million)||UK £151.5m||UK £161.0m||UK £120.0m||UK £123.0m||UK £115.5m||UK £110.9m||UK £108.1m||UK £106.5m||UK £105.7m||UK £105.4m|
|Source of growth rate estimate||Analyst x5||Analyst x4||Analyst x1||Analyst x1||Estimated @ -6.1%||Estimated @ -3.99%||Estimated @ -2.51%||Estimated @ -1.48%||Estimated @ -0.76%||Estimated @ -0.25%|
|Present Value (£,million) Discounted @ 9.0%||UK£139||UK£136||UK£92.8||UK£87.3||UK£75.2||UK£66.3||UK£59.3||UK£53.6||UK£48.8||UK£44.7|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present value of 10-year cash flow (PVCF) = 802 million British pounds
After calculating the present value of future cash flows in the first 10 years, we need to calculate the terminal value, which takes into account all future cash flows after the first phase. A very conservative growth rate is used, which cannot exceed a country’s GDP growth, for a number of reasons. In this case, we used the 5-year average of the 10-year government bond yield (0.9%) to estimate future growth. As with the 10-year “growth period,” we discount future cash flows to today’s value using a cost of equity rate of 9.0%.
final value (TV)= FCF2032 × (1 + g) ÷ (r – g) = £105m × (1 + 0.9%) ÷ (9.0% – 0.9%) = £1.3bn
Present value of terminal value (PVTV)= TV / (1 + r)10= UK£1.3b÷ (1 + 9.0%)10= 562 million British pounds
The total value is the sum of the cash flows for the next ten years plus the discounted future value, giving the total equity value, which in this case is £1.4bn. In the final step, we divide the equity value by the number of shares outstanding. Compared to the current share price of £1.9, the company appears fairly cheap at a 36% discount to the current share price. However, ratings are inaccurate instruments, more like a telescope – move a few degrees and end up in another galaxy. Remember.
The above calculation depends heavily on two assumptions. The first is the discount rate and the other is the cash flows. If you don’t agree with these results, try the calculation yourself and play with the assumptions. The DCF also does not take into account the potential cyclicality of an industry or a company’s future capital needs, so it does not provide a complete picture of a company’s potential performance. As we view Synthomer as a potential shareholder, 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 financing. In this calculation we used 9.0% which is based on a leveraged beta of 1.658. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the industry average of global peers, with an imposed limit of between 0.8 and 2.0, which is a reasonable range for a stable business.
Valuation is only one side of the coin when it comes to building your investment thesis, and it shouldn’t be the only metric you consider when researching 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 determine whether they would understate or overstate the company. For example, changes in the company’s cost of equity or the risk-free rate can significantly affect the valuation. What is the reason that the share price is below the intrinsic value? For Synthomer, we’ve rounded up three other factors to look out for:
- risks: take risks, for example – Synthomer has 5 warning signs (and 2 that don’t sit well with us) that we think you should know about.
- future earnings: What is the growth rate of SYNT compared to its competitors and the broader market? Dive deeper into analyst consensus numbers for the years ahead by interacting with our free analyst growth expectations chart.
- Other solid companies: Low debt, high returns on equity and good past performance are fundamental to a strong company. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered?
hp The Simply Wall St app performs a daily discounted cash flow valuation for each stock on the LSE. If you want to find the calculation for other stocks, just search here.
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This Simply Wall St article is of a general nature. We provide comments based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended as financial advice. It is not a recommendation to buy or sell any stock and does not take into account your goals or financial situation. Our goal is to offer you long-term focused analysis based on fundamental data. Note that our analysis may not take into account the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any of the stocks mentioned.
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