An Intrinsic Calculation For Reckitt Benckiser Group plc (LON:RKT) Suggests It's 48% Undervalued

Does the November share price for Reckitt Benckiser Group plc (LON:RKT) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by taking the forecast future cash flows of the company and discounting them back to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. 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 still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

Our analysis indicates that RKT is potentially undervalued!

Step By Step Through The Calculation

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 start off with, we need to estimate 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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (£, Millions)	UK£2.58b	UK£2.79b	UK£3.07b	UK£3.26b	UK£3.41b	UK£3.54b	UK£3.64b	UK£3.72b	UK£3.79b	UK£3.85b
Growth Rate Estimate Source	Analyst x9	Analyst x9	Analyst x2	Est @ 6.31%	Est @ 4.71%	Est @ 3.6%	Est @ 2.81%	Est @ 2.27%	Est @ 1.88%	Est @ 1.62%
Present Value (£, Millions) Discounted @ 5.3%	UK£2.5k	UK£2.5k	UK£2.6k	UK£2.7k	UK£2.6k	UK£2.6k	UK£2.5k	UK£2.5k	UK£2.4k	UK£2.3k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£25b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 (1.0%) 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 5.3%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = UK£3.9b× (1 + 1.0%) ÷ (5.3%– 1.0%) = UK£91b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£91b÷ ( 1 + 5.3%)¹⁰= UK£55b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is UK£80b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of UK£57.8, the company appears quite good value at a 48% 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

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Reckitt Benckiser Group 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 5.3%, which is based on a levered beta of 0.800. 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.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a discount to intrinsic value? For Reckitt Benckiser Group, we've put together three relevant factors you should further examine:

1. Risks: Take risks, for example - Reckitt Benckiser Group has 1 warning sign we think you should be aware of.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for RKT'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 British stock every day, so if you want to find the intrinsic value of any other stock just search here.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.