A Look At The Fair Value Of Rentokil Initial plc (LON:RTO)

By
Simply Wall St
Published
January 12, 2022
LSE:RTO
Source: Shutterstock

How far off is Rentokil Initial plc (LON:RTO) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by estimating the company's future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

See our latest analysis for Rentokil Initial

The model

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. 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 (£, Millions) UK£350.1m UK£390.4m UK£440.5m UK£533.0m UK£601.0m UK£649.1m UK£687.2m UK£717.2m UK£741.2m UK£760.5m
Growth Rate Estimate Source Analyst x9 Analyst x8 Analyst x2 Analyst x1 Analyst x1 Est @ 8% Est @ 5.87% Est @ 4.38% Est @ 3.33% Est @ 2.6%
Present Value (£, Millions) Discounted @ 6.1% UK£330 UK£347 UK£369 UK£421 UK£447 UK£456 UK£455 UK£447 UK£436 UK£422

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£4.1b

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 5-year average of the 10-year government bond yield (0.9%) 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 6.1%.

Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = UK£760m× (1 + 0.9%) ÷ (6.1%– 0.9%) = UK£15b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£15b÷ ( 1 + 6.1%)10= UK£8.2b

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£12b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of UK£5.3, the company appears about fair value at a 20% 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.

dcf
LSE:RTO Discounted Cash Flow January 12th 2022

The assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 6.1%, which is based on a levered beta of 1.058. 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:

Whilst important, the DCF calculation shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For Rentokil Initial, there are three additional factors you should consider:

  1. Risks: You should be aware of the 1 warning sign for Rentokil Initial we've uncovered before considering an investment in the company.
  2. 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.
  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 British stock every day, so if you want to find the intrinsic value of any other stock just search here.

Discounted cash flow calculation for every stock

Simply Wall St does a detailed discounted cash flow calculation every 6 hours for every stock on the market, so if you want to find the intrinsic value of any company just search here. It’s FREE.

Make Confident Investment Decisions

Simply Wall St's Editorial Team provides unbiased, factual reporting on global stocks using in-depth fundamental analysis.
Find out more about our editorial guidelines and team.