Today we’re going to review one way to estimate the intrinsic value of Resources Connection, Inc. (NASDAQ: RGP) by projecting its future cash flows, then discounting them to today’s value. One way to do this is to use the Discounted Cash Flow (DCF) model. Patterns like these may seem beyond a layman’s comprehension, but they are fairly easy to follow.

There are many ways businesses can be assessed, so we would like to point out that a DCF is not perfect for all situations. If you want to know more about discounted cash flow, the rationale for this calculation can be read in detail in the Simply Wall St.

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Crunch the numbers

We are going to use a two-step DCF model, which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “steady growth”. To begin with, we need to get cash flow estimates for the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated 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 down more in the early years than in subsequent years.

In general, we assume that a dollar today is worth more 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) estimate

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 240 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 step. The Gordon growth formula is used to calculate the 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 their present value at a cost of equity of 6.6%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = US $ 32 million × (1 + 2.0%) ÷ (6.6% – 2.0%) = US $ 717 million

Present value of terminal value (PVTV)= TV / (1 + r)^ten= US $ 717 million ÷ (1 + 6.6%)^ten= US $ 379 million

The total value is the sum of the cash flows for the next ten years plus the final present value, which gives the total value of equity, which in this case is $ 619 million. The last step is then to divide the equity value by the number of shares outstanding. From the current share price of US $ 15.7, the company appears to be roughly at fair value with a 16% discount from the current share price. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.

Important assumptions

Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play with them. 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 view Resources Connection 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 takes debt into account. In this calculation, we used 6.6%, which is based on a leveraged beta of 0.976. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our beta from the industry average beta from globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

Next steps:

While a business valuation is important, ideally it won’t be the only analysis you review for a business. The DCF model is not a perfect equity valuation tool. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. For Resources Connection, we’ve put together three more things you should dig into:

1. Risks: Note that the connection to resources is displayed 4 warning signs in our investment analysis , you must know…
2. Future benefits: How does RGP’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth expectations chart.
3. Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what you might be missing!

PS. Simply Wall St updates its DCF calculation for every US stock every day, 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. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative documents. Simply Wall St has no position in the mentioned stocks.
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