Calculation of the intrinsic value of Rotork plc (LON: ROR)
In this article, we will estimate the intrinsic value of Rotork plc (LON: ROR) by taking expected future cash flows and discounting them to their present value. Our analysis will use the discounted cash flow (DCF) model. There really isn’t much to do, although it might seem quite complex.
We generally think of a business’s value as the present value of all the cash it will generate in the future. However, a DCF is only one evaluation measure among many, and it is not without its flaws. If you still have burning questions about this type of valuation, take a look at the Simply Wall St.
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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.
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 today’s value:
10-year free cash flow (FCF) forecast
|Leverage FCF (£, Million)||UK £ 97.0 million||United Kingdom £ 105.4 million||United Kingdom £ 117.2 million||United Kingdom £ 131.6 million||United Kingdom £ 141.4 million||£ 149.2 million||£ 155.3million in the UK||United Kingdom £ 160.2 million||United Kingdom £ 164.2 million||United Kingdom £ 167.5million|
|Source of estimated growth rate||Analyst x8||Analyst x10||Analyst x7||Analyst x1||East @ 7.45%||Est @ 5.49%||Est @ 4.12%||East @ 3.16%||East @ 2.49%||East @ 2.02%|
|Present value (£, million) discounted at 6.5%||United Kingdom £ 91.1||United Kingdom £ 92.9||United Kingdom £ 97.2||United Kingdom £ 102||United Kingdom £ 103||United Kingdom £ 102||United Kingdom £ 100||United Kingdom £ 97.1||United Kingdom £ 93.5||United Kingdom £ 89.6|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = £ 969 million in the UK
The second stage is also known as terminal value, this is the cash flow of the business after 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 of the 10-year government bond yield of 0.9%. We discount the terminal cash flows to their present value at a cost of equity of 6.5%.
Terminal value (TV)= FCF2030 × (1 + g) ÷ (r – g) = UK £ 168m × (1 + 0.9%) ÷ (6.5% –0.9%) = UK £ 3.0b
Present value of terminal value (PVTV)= TV / (1 + r)ten= UK £ 3.0b (1 + 6.5%)ten= £ 1.6 billion in the UK
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is £ 2.6 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of UK £ 3.4, 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.
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. If you don’t agree with these results, try the calculation yourself and play with the 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 full picture of a company’s potential performance. Since we view Rotork 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 6.5%, which is based on a leveraged beta of 1.044. 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 a limit imposed between 0.8 and 2.0, which is a reasonable range for a stable business.
To move on :
While important, calculating DCF is just one of the many factors you need to assess 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, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. For Rotork, we’ve put together three important factors you should explore:
- Risks: To do this, you need to know the 1 warning sign we spotted with Rotork.
- Future benefits: How does MMR’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 might not have considered!
PS. The Simply Wall St app performs a daily discounted cash flow assessment for every share on the LSE. If you want to find the calculation for other actions, 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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