A look at the fair value of Ruth’s Hospitality Group, Inc. (NASDAQ: RUTH)
Today, we’re going to review a valuation method used to estimate the attractiveness of Ruth’s Hospitality Group, Inc. (NASDAQ: RUTH) as an investment opportunity by projecting its future cash flows and then evaluating it. discounting them to today’s value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. Believe it or not, it’s not too hard to follow, as you will see in our example!
Remember, however, that there are many ways to estimate the value of a business, and a DCF is just one method. For those who are passionate about equity analysis, the Simply Wall St analysis template here may be something of interest to you.
Step by step in the calculation
We use what is called a two-step model, which simply means that we have two different periods of growth rate for the cash flow of the business. Usually the first stage is higher growth and the second stage is lower growth stage. 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.
Generally, we assume that a dollar today is worth more than a dollar in the future, and so the sum of these future cash flows is then discounted to present value:
10-year free cash flow (FCF) forecast
2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | |
Leverage FCF ($, Millions) | US $ 31.0 million | US $ 45.6 million | US $ 48.7 million | US $ 51.3 million | $ 53.5 million | US $ 55.5 million | US $ 57.2 million | 58.8 million US dollars | US $ 60.3 million | US $ 61.8 million |
Source of estimated growth rate | Analyst x1 | Analyst x1 | Est @ 6.79% | East @ 5.35% | East @ 4.34% | East @ 3.64% | Is @ 3.14% | East @ 2.8% | Is 2.55% | East @ 2.39% |
Present value (in millions of dollars) discounted at 8.9% | 28.5 USD | US $ 38.5 | US $ 37.7 | US $ 36.5 | US $ 35.0 | $ 33.3 | $ 31.6 | $ 29.8 | US $ 28.1 | US $ 26.4 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = 325 million US dollars
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 8.9%.
Terminal value (TV)= FCF_{2030} × (1 + g) ÷ (r – g) = US $ 62 million × (1 + 2.0%) ÷ (8.9% – 2.0%) = US $ 916 million
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= US $ 916 million ÷ (1 + 8.9%)^{ten}= US $ 391 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 $ 716 million. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of US $ 22.8, the company appears to be around fair value at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it’s best to take this as a rough estimate, not precise down to the last penny.
NasdaqGS: RUTH Discounted cash flow June 7, 2021
The hypotheses
We draw your attention to the fact 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 view Ruth’s Hospitality Group as a potential shareholder, 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 into account debt. In this calculation, we used 8.9%, which is based on a leveraged beta of 1.458. 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.
Looking forward:
Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn’t be the only metric you look at when researching a business. DCF models are not the alpha and omega of investment valuation. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. If a business grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output can be very different. For Ruth’s Hospitality Group, we have put together three relevant things that you should evaluate:
- Risks: As an example, we have found 3 warning signs for Ruth’s Hospitality Group that you need to consider before investing here.
- Future benefits: How does RUTH’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.
- Other strong companies: 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 trading fundamentals to see if there are other companies you may not have considered!
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.
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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