Are Investors Undervaluing Redcentric plc (LON:RCN) By 30%?

Today we will run through one way of estimating the intrinsic value of Redcentric plc (LON:RCN) by estimating the company’s future cash flows and discounting them to their present value. I will be using the Discounted Cash Flow (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward.

We generally believe that a company’s value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

View our latest analysis for Redcentric

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
Levered FCF (£, Millions) UK£10.4m UK£14.1m UK£14.5m UK£14.7m UK£15.0m UK£15.2m UK£15.3m UK£15.4m UK£15.6m UK£15.7m
Growth Rate Estimate Source Analyst x1 Analyst x1 Est @ 2.58% Est @ 1.96% Est @ 1.53% Est @ 1.23% Est @ 1.02% Est @ 0.87% Est @ 0.77% Est @ 0.7%
Present Value (£, Millions) Discounted @ 7.2% UK£9.7 UK£12.3 UK£11.7 UK£11.2 UK£10.6 UK£10.0 UK£9.4 UK£8.8 UK£8.3 UK£7.8

(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£99m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 10-year government bond rate (0.5%) 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 7.2%.

Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = UK£16m× (1 + 0.5%) ÷ 7.2%– 0.5%) = UK£235m

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£235m÷ ( 1 + 7.2%)10= UK£117m

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£216m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK£1.0, the company appears quite good value at a 30% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula – garbage in, garbage out.

AIM:RCN Intrinsic value, December 5th 2019
AIM:RCN Intrinsic value, December 5th 2019

Important assumptions

Now 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 Redcentric 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 7.2%, which is based on a levered beta of 1.104. 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.

Next Steps:

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. What is the reason for the share price to differ from the intrinsic value? For Redcentric, I’ve put together three relevant aspects you should look at:

  1. Financial Health: Does RCN have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
  2. Future Earnings: How does RCN’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: Are there other high quality stocks you could be holding instead of RCN? 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 GB 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 editorial-team@simplywallst.com. 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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.