Is Hill & Smith PLC (LON:HILS) Worth UK£19.7 Based On Its Intrinsic Value?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Hill & Smith fair value estimate is UK£14.86

• Current share price of UK£19.66 suggests Hill & Smith is potentially 32% overvalued

• Our fair value estimate is 36% lower than Hill & Smith's analyst price target of UK£23.29

How far off is Hill & Smith PLC (LON:HILS) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the expected future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for Hill & Smith

The Method

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) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (£, Millions)	UK£75.8m	UK£81.8m	UK£88.4m	UK£86.3m	UK£85.2m	UK£85.0m	UK£85.3m	UK£85.9m	UK£86.8m	UK£87.9m
Growth Rate Estimate Source	Analyst x5	Analyst x5	Analyst x3	Est @ -2.45%	Est @ -1.18%	Est @ -0.30%	Est @ 0.32%	Est @ 0.76%	Est @ 1.06%	Est @ 1.27%
Present Value (£, Millions) Discounted @ 8.2%	UK£70.1	UK£69.9	UK£69.8	UK£62.9	UK£57.5	UK£53.0	UK£49.1	UK£45.7	UK£42.7	UK£40.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£561m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 8.2%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£88m× (1 + 1.8%) ÷ (8.2%– 1.8%) = UK£1.4b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£1.4b÷ ( 1 + 8.2%)¹⁰= UK£633m

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£1.2b. 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£19.7, the company appears reasonably expensive at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf

The 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. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Hill & Smith 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 8.2%, which is based on a levered beta of 1.173. 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 Hill & Smith

Strength

• Earnings growth over the past year exceeded the industry.

• 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 Metals and Mining market.

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

Opportunity

• Annual revenue is forecast to grow faster than the British market.

Threat

• Annual earnings are forecast to grow slower than the British market.

Moving On:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for 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?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. Why is the intrinsic value lower than the current share price? For Hill & Smith, we've compiled three essential factors you should consider:

1. Risks: As an example, we've found 1 warning sign for Hill & Smith that you need to consider before investing here.

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for HILS's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

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. 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.

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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.