Key Insights

The projected fair value for Synlait Milk is NZ$2.00 based on 2 Stage Free Cash Flow to Equity Current share price of NZ$1.28 suggests Synlait Milk is potentially 36% undervalued Analyst price target for SML is NZ$1.92 which is 4.2% below our fair value estimate

Does the September share price for Synlait Milk Limited (NZSE:SML) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

Check out our latest analysis for Synlait Milk

The Model

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To begin with, we have to get estimates of 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 (NZ$, Millions)  NZ$51.2m NZ$41.4m NZ$36.9m NZ$30.5m NZ$27.2m NZ$25.3m NZ$24.2m NZ$23.7m NZ$23.5m NZ$23.5m Growth Rate Estimate Source Analyst x2 Analyst x2 Analyst x2 Analyst x1 Est @ -10.96% Est @ -6.98% Est @ -4.19% Est @ -2.24% Est @ -0.87% Est @ 0.08% Present Value (NZ$, Millions) Discounted @ 7.6%  NZ$47.6 NZ$35.7 NZ$29.6 NZ$22.7 NZ$18.8 NZ$16.3 NZ$14.5 NZ$13.1 NZ$12.1 NZ$11.3

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = NZ$222m



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 (2.3%) 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 7.6%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = NZ$23m× (1 + 2.3%) ÷ (7.6%– 2.3%) = NZ$451m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= NZ$451m÷ ( 1 + 7.6%)10= NZ$216m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is NZ$438m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of NZ$1.3, the company appears quite undervalued at a 36% 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

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 Synlait Milk 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 7.6%, which is based on a levered beta of 1.065. 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 Synlait Milk

Strength

No major strengths identified for SML.

Weakness

Interest payments on debt are not well covered.

Opportunity

Expected to breakeven next year.

Has sufficient cash runway for more than 3 years based on current free cash flows.

Good value based on P/S ratio and estimated fair value.

Threat

Debt is not well covered by operating cash flow.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for 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?" 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 Synlait Milk, we've put together three important aspects you should assess:

Risks: Every company has them, and we've spotted  1 warning sign for Synlait Milk  you should know about. Future Earnings: How does SML'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. 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 NZSE 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.