Does the September share price for Raytheon Technologies Corporation (NYSE:RTX) 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 their present value. This will be done using the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis 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.
Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) forecast
|Levered FCF ($, Millions)||US$6.39b||US$7.86b||US$9.13b||US$10.3b||US$11.2b||US$11.9b||US$12.5b||US$13.1b||US$13.5b||US$14.0b|
|Growth Rate Estimate Source||Analyst x9||Analyst x8||Analyst x5||Analyst x3||Est @ 8.5%||Est @ 6.54%||Est @ 5.18%||Est @ 4.22%||Est @ 3.55%||Est @ 3.08%|
|Present Value ($, Millions) Discounted @ 7.0%||US$6.0k||US$6.9k||US$7.4k||US$7.9k||US$8.0k||US$7.9k||US$7.8k||US$7.6k||US$7.3k||US$7.1k|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$74b
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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 7.0%.
Terminal Value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US$14b× (1 + 2.0%) ÷ (7.0%– 2.0%) = US$282b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$282b÷ ( 1 + 7.0%)10= US$143b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$217b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of US$83.4, the company appears quite undervalued at a 42% 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 calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Raytheon Technologies 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 7.0%, which is based on a levered beta of 1.070. 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.
Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. 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 Raytheon Technologies, there are three further aspects you should explore:
- Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Raytheon Technologies (at least 1 which is concerning) , and understanding these should be part of your investment process.
- Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for RTX's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
- 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. Simply Wall St updates its DCF calculation for every American 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.
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