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Smith & Wesson (NASDAQ:SWHC) has spooked many investors as of late. Concerns over regulatory gun reform continues to weigh on Smith & Wesson, trading well off its 52-week high of $11.25. I like to think of this as the perfect time to buy S&W at a discount, well ahead of quarterly earnings next month. Using discounted cash flows and a time horizon of 15 years, We can determine fair value for Smith & Wesson in best and worst case scenarios.

How Scenarios are Calculated:

Growth value=E(0) x(1-xn)/(1-x), where x=(1+g)/(1+d), n is the number of years business will grow at the rate of g; d is the discount rate. E(0) is the earnings of the company in the current year.

Terminal value=E(0) xny(1-ym)/(1-y), where y=(1+t)/(1+d), where m is the years of terminal growth; t is the terminal growth rate.

Best Case Scenario

I am a glass half full kind of guy. Therefore, let's look at the best case fair value. For this calculation, I have used an optimistic growth rate of 30% for the next 5 years. This growth rate was chosen because it also happens to be the 5 year target growth rate set by Nasdaq third party research. I then used a terminal growth rate of 4% for 10 years. This was based on the fact that 4% is an industry standard terminal growth rate when calculating fair value. Finally, cash flows were discounted at 12%, also a very common industry value.

Best Case Scenario

This equates to a fair value of approximately $19.02/share for Smith & Wesson. Keep in mind again that this is a best case scenario, which speculates on growth many years in the future. Next, we will examine a worst case scenario.

Worst Case

In order to calculate a worst case fair value for this gun maker, we must assume some kind of assault weapon ban will pass. Data suggests that approximately 20% of Smith & Wesson sales come from assault weapons. Therefore, we will use 80% of Smith & Wessons 10 year revenue growth rate (8.7%) in our calculations.

Worst Case Scenario

Using this worst case scenario, we can see that Smith & Wesson is currently trading fairly close to this worst case scenario fair market value.

Bottom Line

This data shows us two outcomes at completely different sides of the spectrum. Averaging these two outcomes, median fair market value of each situation is $13.67/share. This calculation shows that Smith & Wesson is approximately 49% undervalued, assuming you give both outcomes a 50/50 chance. With this much upside, Establishing a long position on this stock is a great play.

Source: Smith & Wesson: 49% Below Fair Market Value