Lynas Rare Earths Limited (ASX:LYC) Shares Could Be 24% Below Their Intrinsic Value Estimate

How far off is Lynas Rare Earths Limited (ASX:LYC) 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 today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

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. 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 Lynas Rare Earths

The model

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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (A$, Millions)	-AU$128.1m	AU$240.8m	AU$515.3m	AU$475.0m	AU$452.7m	AU$440.4m	AU$434.5m	AU$432.8m	AU$434.1m	AU$437.4m
Growth Rate Estimate Source	Analyst x2	Analyst x3	Analyst x2	Analyst x1	Est @ -4.69%	Est @ -2.72%	Est @ -1.35%	Est @ -0.39%	Est @ 0.29%	Est @ 0.76%
Present Value (A$, Millions) Discounted @ 6.5%	-AU$120	AU$212	AU$427	AU$369	AU$331	AU$302	AU$280	AU$262	AU$246	AU$233

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$2.5b

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 5-year average of the 10-year government bond yield of 1.9%. We discount the terminal cash flows to today's value at a cost of equity of 6.5%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = AU$437m× (1 + 1.9%) ÷ (6.5%– 1.9%) = AU$9.6b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$9.6b÷ ( 1 + 6.5%)¹⁰= AU$5.1b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$7.7b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of AU$6.4, the company appears a touch undervalued at a 24% 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.

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. 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 Lynas Rare Earths 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 6.5%, which is based on a levered beta of 1.057. 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.

Looking Ahead:

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. Can we work out why the company is trading at a discount to intrinsic value? For Lynas Rare Earths, we've compiled three additional elements you should further research:

1. Risks: For example, we've discovered 1 warning sign for Lynas Rare Earths that you should be aware of before investing here.
2. Future Earnings: How does LYC'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 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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the ASX every day. If you want to find the calculation for other stocks just search here.

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.

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