Ritchie Bros. Fair Value Estimate Auctioneers Incorporated (NYSE: RBA)
Today we are going to review a valuation method used to estimate the attractiveness of Ritchie Bros. Auctioneers Incorporated (NYSE: RBA) as an investment opportunity by estimating the company’s future cash flows and discounting them to their present 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.
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. Anyone who wants to learn a little more about intrinsic value should read the Simply Wall St.
Check out our latest analysis for Ritchie Bros. Auctioneers
The method
We use the 2-step growth model, which simply means that we take into account two stages of business growth. In the initial period, the business can have a higher growth rate, and the second stage is usually assumed to have a stable growth rate. To begin with, we need to estimate the next ten years of cash flow. 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) estimate
2021 | 2022 | 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | |
Leverage FCF ($, Millions) | US $ 242.7 million | 281.5 million US dollars | US $ 309.3 million | US $ 331.8 million | US $ 349.6 million | US $ 363.5 million | US $ 375.7 million | US $ 386.8 million | US $ 397.1 million | US $ 406.9 million |
Source of estimated growth rate | Analyst x2 | Analyst x2 | Analyst x1 | Analyst x1 | Analyst x1 | Est @ 3.96% | East @ 3.37% | Est @ 2.96% | East @ 2.67% | East @ 2.46% |
Present value (in millions of dollars) discounted at 6.6% | $ 228 | US $ 248 | $ 256 | US $ 257 | US $ 254 | US $ 248 | US $ 241 | 232 USD | $ 224 | $ 215 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 2.4 billion
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 2.0%. We discount the terminal cash flows to their present value at a cost of equity of 6.6%.
Terminal value (TV)= FCF_{2030} × (1 + g) ÷ (r – g) = US $ 407 million × (1 + 2.0%) ÷ (6.6% – 2.0%) = US $ 9.1 billion
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= US $ 9.1b (1 + 6.6%)^{ten}= 4.8 billion US dollars
Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is $ 7.2 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. From the current price of US $ 59.8, the company appears to be roughly at fair value at a discount of 8.2% from the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in another galaxy. Keep this in mind.
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 full picture of a company’s potential performance. Since we consider Ritchie Bros. Auctioneers like 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 0.971. 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.
Next steps:
While valuing a business is important, it’s just one of the many factors you need to assess for a business. It is not possible to achieve a rock-solid valuation with a DCF model. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. For Ritchie Bros. Auctioneers, we’ve put together three more things you should take a look at:
- Risks: For example, we discovered 2 warning signs for auctioneers Ritchie Bros. which you should know before investing here.
- Management: Have insiders increased their stocks to take advantage of market sentiment about RBA’s future prospects? Check out our management and board analysis with information on CEO compensation and governance factors.
- 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. The Simply Wall St app performs a daily discounted cash flow assessment for every NYSE share. 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 any of the stocks mentioned.
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