A look at the fair value of Redrow plc (LON:RDW)
How far is Redrow plc (LON:RDW) from its intrinsic value? Using the most recent financial data, we will examine whether the stock price is fair by estimating the company’s future cash flows and discounting them to their present value. Our analysis will use the discounted cash flow (DCF) model. This may sound complicated, but it’s actually quite simple!
Businesses can be valued in many ways, which is why we emphasize that a DCF is not perfect for all situations. For those who are passionate about stock analysis, the Simply Wall St analysis template here may interest you.
Check out our latest analysis for Redrow
We use the 2-stage growth model, which simply means that we consider two stages of business growth. In the initial period, the company may have a higher growth rate, and the second stage is generally assumed to have a stable growth rate. To start, we need to estimate the cash flows for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we discount the value of these future cash flows to their estimated value in today’s dollars:
Estimated free cash flow (FCF) over 10 years
|Leveraged FCF (£, millions)||UK£177.3m||UK£145.7m||UK£126.6m||UK£115.5m||UK£108.7m||UK£104.6m||UK£102.0m||UK£100.6m||UK£99.9m||UK£99.7m|
|Growth rate estimate Source||Analyst x5||Analyst x6||Analyst x3||Is @ -8.78%||Is @ -5.87%||Is @ -3.83%||Is @ -2.4%||Is @ -1.4%||Is @ -0.7%||Is @ -0.21%|
|Present value (£, million) discounted at 6.1%||UK£167||UK£130||UK£106||UK£91.3||United Kingdom£81.0||UK£73.4||UK£67.6||UK£62.8||UK£58.8||UK£55.3|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = UK £893 million
After calculating the present value of future cash flows over the initial 10-year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 0.9%. We discount terminal cash flows to present value at a cost of equity of 6.1%.
Terminal value (TV)= FCF2032 × (1 + g) ÷ (r – g) = UK£100m × (1 + 0.9%) ÷ (6.1%– 0.9%) = UK£2.0b
Present value of terminal value (PVTV)= TV / (1 + r)ten= UK£2.0b÷ ( 1 + 6.1%)ten= UK £1.1 billion
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is £2.0 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current UK share price of £5.1, the company appears to be about fair value at a 14% discount to the current share price. The assumptions of any calculation have a big impact on the valuation, so it’s best to consider this as a rough estimate, not accurate down to the last penny.
We emphasize 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 assessment of a company’s future performance, so try the math yourself and check your own assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Redrow 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 factors in debt. In this calculation, we used 6.1%, which is based on a leveraged beta of 1.060. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won’t be the only piece of analysis you look at 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 must be true for this stock to be under/overvalued?” If a company grows at a different pace, or if its cost of equity or risk-free rate changes sharply, output may be very different. For Redrow, we have put together three important factors that you should consider in more detail:
- Risks: For example, we have identified 2 warning signs for Redrow of which you should be aware.
- Future earnings: How does RDW’s growth rate compare to its peers and the wider market? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
- Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of what you might be missing!
PS. Simply Wall St updates its DCF calculation for every UK stock daily, so if you want to find the intrinsic value of any other stock, just search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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