Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Reliance Worldwide Corporation Limited (ASX:RWC) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.
We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To begin with, we have to get estimates of the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
Generally we assume that a dollar today is more valuable 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) forecast
2023
2024
2025
2026
2027
2028
2029
2030
2031
2032
Levered FCF ($, Millions)
US$143.2m
US$162.8m
US$169.2m
US$199.5m
US$208.1m
US$215.0m
US$221.2m
US$226.9m
US$232.4m
US$237.6m
Growth Rate Estimate Source
Analyst x6
Analyst x6
Analyst x5
Analyst x1
Analyst x1
Est @ 3.30%
Est @ 2.89%
Est @ 2.60%
Est @ 2.40%
Est @ 2.26%
Present Value ($, Millions) Discounted @ 9.2%
US$131
US$136
US$130
US$140
US$134
US$127
US$119
US$112
US$105
US$98.3
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = US$1.2b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.9%. We discount the terminal cash flows to today's value at a cost of equity of 9.2%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$3.3b÷ ( 1 + 9.2%)10= US$1.4b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$2.6b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of AU$4.1, the company appears about fair value at a 19% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
ASX:RWC Discounted Cash Flow May 1st 2023
The Assumptions
Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. The DCF also does not consider the possible cyclicality of an industry, or a company's future capital requirements, so it does not give a full picture of a company's potential performance. Given that we are looking at Reliance Worldwide 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 accounts for debt. In this calculation we've used 9.2%, which is based on a levered beta of 1.229. Beta is a measure of a stock's volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
SWOT Analysis for Reliance Worldwide
Strength
Debt is well covered by earnings and cashflows.
Dividends are covered by earnings and cash flows.
Weakness
Earnings growth over the past year underperformed the Building industry.
Dividend is low compared to the top 25% of dividend payers in the Building market.
Opportunity
Annual earnings are forecast to grow for the next 3 years.
Good value based on P/E ratio and estimated fair value.
Threat
Annual earnings are forecast to grow slower than the Australian market.
Looking Ahead:
Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For Reliance Worldwide, there are three essential aspects you should further research:
Future Earnings: How does RWC's growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.
Other High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the ASX every day. If you want to find the calculation for other stocks just search here.
Have feedback on this article? Concerned about the content?Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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