Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Ridley Corporation Limited (ASX:RIC) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.
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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. In the first stage we need to estimate the cash flows to the business over the next ten years. 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.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, and so the sum of these future cash flows is then discounted to today's value:
10-year free cash flow (FCF) estimate
2025
2026
2027
2028
2029
2030
2031
2032
2033
2034
Levered FCF (A$, Millions)
AU$48.1m
AU$49.2m
AU$53.7m
AU$50.3m
AU$48.5m
AU$47.6m
AU$47.3m
AU$47.5m
AU$47.9m
AU$48.6m
Growth Rate Estimate Source
Analyst x2
Analyst x2
Analyst x1
Est @ -6.27%
Est @ -3.67%
Est @ -1.84%
Est @ -0.57%
Est @ 0.33%
Est @ 0.95%
Est @ 1.39%
Present Value (A$, Millions) Discounted @ 5.7%
AU$45.5
AU$44.0
AU$45.5
AU$40.3
AU$36.7
AU$34.1
AU$32.1
AU$30.5
AU$29.1
AU$27.9
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = AU$366m
The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (2.4%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 5.7%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$1.5b÷ ( 1 + 5.7%)10= AU$867m
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$1.2b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of AU$2.2, the company appears quite undervalued at a 43% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.
ASX:RIC Discounted Cash Flow August 21st 2024
Important Assumptions
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Ridley 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 5.7%, which is based on a levered beta of 0.800. 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 Ridley
Strength
Debt is not viewed as a risk.
Dividends are covered by earnings and cash flows.
Weakness
Earnings declined over the past year.
Dividend is low compared to the top 25% of dividend payers in the Food market.
Opportunity
Annual earnings are forecast to grow faster than the Australian market.
Good value based on P/E ratio and estimated fair value.
Threat
Revenue is forecast to grow slower than 20% per year.
Next Steps:
Valuation is only one side of the coin in terms of building your investment thesis, and it is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For Ridley, there are three additional aspects you should further research:
Risks: As an example, we've found 1 warning sign for Ridley that you need to consider before investing here.
Future Earnings: How does RIC'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 Solid Businesses: 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 business fundamentals to see if there are other companies you may not have considered!
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.
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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.
