In this article we are going to estimate the intrinsic value of Rentokil Initial plc (LON:RTO) by projecting its future cash flows and then discounting them to today’s value. I will use the Discounted Cash Flow (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward.
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 are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second ‘steady growth’ period. 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 need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) forecast
|Levered FCF (£, Millions)||UK£227.5m||UK£316.4m||UK£340.2m||UK£356.7m||UK£369.3m||UK£379.1m||UK£386.7m||UK£392.7m||UK£397.7m||UK£401.8m|
|Growth Rate Estimate Source||Analyst x6||Analyst x6||Analyst x5||Est @ 4.84%||Est @ 3.55%||Est @ 2.64%||Est @ 2.01%||Est @ 1.56%||Est @ 1.25%||Est @ 1.04%|
|Present Value (£, Millions) Discounted @ 5.5%||UK£216||UK£284||UK£290||UK£288||UK£282||UK£275||UK£265||UK£255||UK£245||UK£235|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£2.6b
After calculating the present value of future cash flows in the intial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 0.5%. We discount the terminal cash flows to today’s value at a cost of equity of 5.5%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = UK£402m× (1 + 0.5%) ÷ 5.5%– 0.5%) = UK£8.1b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£8.1b÷ ( 1 + 5.5%)10= UK£4.7b
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£7.4b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£3.9, the company appears about fair value at a 0.9% 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.
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 Rentokil Initial 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 5.5%, which is based on a levered beta of 0.822. 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 Rentokil Initial, There are three additional factors you should look at:
- Risks: Every company has them, and we’ve spotted 4 warning signs for Rentokil Initial (of which 1 is a bit unpleasant!) you should know about.
- Future Earnings: How does RTO’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 Solid Businesses: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid business fundamentals to see if there are other companies you may not have considered!
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 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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