Is There An Opportunity With DS Smith Plc's (LON:SMDS) 45% Undervaluation?

Key Insights

• The projected fair value for DS Smith is UK£5.79 based on 2 Stage Free Cash Flow to Equity

• DS Smith's UK£3.18 share price signals that it might be 45% undervalued

• Our fair value estimate is 47% higher than DS Smith's analyst price target of UK£3.94

Today we will run through one way of estimating the intrinsic value of DS Smith Plc (LON:SMDS) by taking the expected future cash flows and discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. 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 DS Smith

What's The Estimated Valuation?

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (£, Millions)	UK£350.7m	UK£397.8m	UK£406.8m	UK£369.0m	UK£500.0m	UK£524.4m	UK£544.2m	UK£560.6m	UK£574.6m	UK£586.7m
Growth Rate Estimate Source	Analyst x7	Analyst x6	Analyst x7	Analyst x1	Analyst x1	Est @ 4.87%	Est @ 3.78%	Est @ 3.02%	Est @ 2.49%	Est @ 2.11%
Present Value (£, Millions) Discounted @ 7.4%	UK£327	UK£345	UK£329	UK£278	UK£350	UK£342	UK£331	UK£317	UK£303	UK£288

("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 1.2%. We discount the terminal cash flows to today's value at a cost of equity of 7.4%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = UK£587m× (1 + 1.2%) ÷ (7.4%– 1.2%) = UK£9.7b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£9.7b÷ ( 1 + 7.4%)¹⁰= UK£4.8b

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£8.0b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£3.2, the company appears quite good value at a 45% discount to where the stock price trades currently. 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

Now 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 DS 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 7.4%, which is based on a levered beta of 0.880. 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 DS 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 Packaging market.

Opportunity

• Trading below our estimate of fair value by more than 20%.

Threat

• Annual earnings are forecast to decline for the next 3 years.

Moving On:

Whilst important, the DCF calculation 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. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or 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. What is the reason for the share price sitting below the intrinsic value? For DS Smith, we've put together three further elements you should assess:

1. Risks: You should be aware of the 2 warning signs for DS Smith (1 is a bit concerning!) we've uncovered before considering an investment in the company.

2. Future Earnings: How does SMDS'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. 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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