Is There An Opportunity With Sleep Number Corporation's (NASDAQ:SNBR) 48% Undervaluation?

Key Insights

• The projected fair value for Sleep Number is US$14.44 based on 2 Stage Free Cash Flow to Equity
• Sleep Number is estimated to be 48% undervalued based on current share price of US$7.47
• Analyst price target for SNBR is US$5.50 which is 62% below our fair value estimate

Today we will run through one way of estimating the intrinsic value of Sleep Number Corporation (NASDAQ:SNBR) by projecting its future cash flows and then discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

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.

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Step By Step Through The Calculation

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 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

	2026	2027	2028	2029	2030	2031	2032	2033	2034	2035
Levered FCF ($, Millions)	US$15.5m	US$18.1m	US$25.0m	US$29.5m	US$33.5m	US$37.0m	US$40.1m	US$42.8m	US$45.3m	US$47.5m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Analyst x1	Est @ 17.99%	Est @ 13.57%	Est @ 10.48%	Est @ 8.31%	Est @ 6.80%	Est @ 5.74%	Est @ 4.99%
Present Value ($, Millions) Discounted @ 13%	US$13.8	US$14.3	US$17.6	US$18.4	US$18.6	US$18.3	US$17.6	US$16.7	US$15.7	US$14.6

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$165m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 3.3%. We discount the terminal cash flows to today's value at a cost of equity of 13%.

Terminal Value (TV)= FCF₂₀₃₅ × (1 + g) ÷ (r – g) = US$48m× (1 + 3.3%) ÷ (13%– 3.3%) = US$531m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$531m÷ ( 1 + 13%)¹⁰= US$164m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$329m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$7.5, the company appears quite undervalued at a 48% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Sleep Number 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 13%, which is based on a levered beta of 2.000. 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.

View our latest analysis for Sleep Number

SWOT Analysis for Sleep Number

Next Steps:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Why is the intrinsic value higher than the current share price? For Sleep Number, there are three further factors you should explore:

1. Risks: Every company has them, and we've spotted 3 warning signs for Sleep Number (of which 2 shouldn't be ignored!) you should know about.
2. Future Earnings: How does SNBR'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 NASDAQGS 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.