Stock Analysis

# An Intrinsic Calculation For Redbubble Limited (ASX:RBL) Suggests It's 48% Undervalued

•  Updated

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Redbubble Limited (ASX:RBL) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

See our latest analysis for Redbubble

### 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. 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, 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) estimate

 2022 2023 2024 2025 2026 2027 2028 2029 2030 2031 Levered FCF (A\$, Millions) AU\$17.6m AU\$41.6m AU\$68.4m AU\$80.1m AU\$90.1m AU\$98.5m AU\$105.5m AU\$111.3m AU\$116.3m AU\$120.5m Growth Rate Estimate Source Analyst x3 Analyst x3 Analyst x3 Est @ 17.09% Est @ 12.52% Est @ 9.32% Est @ 7.09% Est @ 5.52% Est @ 4.42% Est @ 3.65% Present Value (A\$, Millions) Discounted @ 6.4% AU\$16.6 AU\$36.7 AU\$56.8 AU\$62.5 AU\$66.1 AU\$68.0 AU\$68.4 AU\$67.9 AU\$66.6 AU\$64.9

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU\$574m

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 6.4%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = AU\$120m× (1 + 1.9%) ÷ (6.4%– 1.9%) = AU\$2.7b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU\$2.7b÷ ( 1 + 6.4%)10= AU\$1.5b

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\$2.0b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of AU\$3.8, the company appears quite good value at a 48% 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.

### The 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 Redbubble 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 6.4%, which is based on a levered beta of 1.033. 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.

### Moving On:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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 sitting below the intrinsic value? For Redbubble, there are three important factors you should explore:

1. Risks: For example, we've discovered 2 warning signs for Redbubble 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 RBL'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. 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.

### Valuation is complex, but we're helping make it simple.

Find out whether Redbubble is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.

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