How far off is ReadyTech Holdings Limited (ASX:RDY) 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. This is done using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!
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.
Crunching the numbers
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. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company’s last 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) estimate
|Levered FCF (A$, Millions)||AU$6.11m||AU$6.70m||AU$7.18m||AU$7.57m||AU$7.88m||AU$8.13m||AU$8.33m||AU$8.51m||AU$8.66m||AU$8.80m|
|Growth Rate Estimate Source||Est @ 13.53%||Est @ 9.79%||Est @ 7.18%||Est @ 5.35%||Est @ 4.07%||Est @ 3.17%||Est @ 2.54%||Est @ 2.1%||Est @ 1.8%||Est @ 1.58%|
|Present Value (A$, Millions) Discounted @ 7.0%||AU$5.7||AU$5.9||AU$5.9||AU$5.8||AU$5.6||AU$5.4||AU$5.2||AU$5.0||AU$4.7||AU$4.5|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$53m
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 10-year government bond rate of 1.1%. We discount the terminal cash flows to today’s value at a cost of equity of 7.0%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = AU$8.8m× (1 + 1.1%) ÷ 7.0%– 1.1%) = AU$151m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$151m÷ ( 1 + 7.0%)10= AU$77m
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is AU$130m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of AU$1.4, the company appears about fair value at a 16% 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.
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. You don’t have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 ReadyTech Holdings 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 7.0%, which is based on a levered beta of 1.086. 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.
Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. 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. For ReadyTech Holdings, We’ve put together three important factors you should further research:
- Risks: For example, we’ve discovered 3 warning signs for ReadyTech Holdings (1 is potentially serious!) that you should be aware of before investing here.
- Future Earnings: How does RDY’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. Simply Wall St updates its DCF calculation for every AU stock every day, so if you want to find the intrinsic value of any other stock just search here.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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