Are Iluka Resources Limited (ASX:ILU) Investors Paying Above The Intrinsic Value?

Key Insights

• Using the Dividend Discount Model, Iluka Resources fair value estimate is AU$3.26
• Current share price of AU$4.27 suggests Iluka Resources is potentially 31% overvalued
• Analyst price target for ILU is AU$5.90, which is 81% above our fair value estimate

Does the March share price for Iluka Resources Limited (ASX:ILU) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the expected future cash flows and discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

See our latest analysis for Iluka Resources

Crunching The Numbers

As Iluka Resources operates in the metals and mining sector, we need to calculate the intrinsic value slightly differently. Instead of using free cash flows, which are hard to estimate and often not reported by analysts in this industry, dividends per share (DPS) payments are used. Unless a company pays out the majority of its FCF as a dividend, this method will typically underestimate the value of the stock. The 'Gordon Growth Model' is used, which simply assumes that dividend payments will continue to increase at a sustainable growth rate forever. For a number of reasons a very conservative growth rate is used that cannot exceed that of a company's Gross Domestic Product (GDP). In this case we used the 5-year average of the 10-year government bond yield (2.7%). The expected dividend per share is then discounted to today's value at a cost of equity of 8.0%. Compared to the current share price of AU$4.3, the company appears reasonably expensive at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

Value Per Share = Expected Dividend Per Share / (Discount Rate - Perpetual Growth Rate)

= AU$0.2 / (8.0% – 2.7%)

= AU$3.3

The Assumptions

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. 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 Iluka Resources 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 8.0%, which is based on a levered beta of 1.217. 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.

SWOT Analysis for Iluka Resources

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it 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. 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. Why is the intrinsic value lower than the current share price? For Iluka Resources, we've put together three relevant items you should assess:

1. Risks: For example, we've discovered 1 warning sign for Iluka Resources that you should be aware of before investing here.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for ILU's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
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. Simply Wall St updates its DCF calculation for every Australian stock every day, so if you want to find the intrinsic value of any other stock just search here.

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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.