In this article I am going to calculate the intrinsic value of Rio Tinto Limited (ASX:RIO) using the discounted cash flows (DCF) model. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. If you are reading this after January 2018 then I highly recommend you check out the latest calculation for Rio Tinto here.
What’s the value?
I use what is known as the 2-stage 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 perpetual stable growth rate. To begin, I took the analyst consensus forecast of RIO’s levered free cash flow (FCF) over the next five years and discounted these values at the cost of equity of 10.25%. When estimates weren’t available, I’ve extrapolated the average annual growth rate over the previous five years, capped at a reasonable level. This resulted in a present value of 5-year cash flow of $25,209.0M. Keen to understand how I arrived at this number? Read our detailed analysis here.
The graph above shows how RIO’s top and bottom lines are expected to move in the future, which should give you an idea of RIO’s outlook. Secondly, I calculate the terminal value, which accounts for all the future cash flows after the five years. I think it’s suitable to use the 10-year government bond rate of 2.8% as the steady growth rate, which is rightly below GDP growth, but more towards the conservative side. After discounting the terminal value back five years, the present value becomes $53,415.3M.
The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is $78,624.3M. In the final step we divide the equity value by the number of shares outstanding. This results in an intrinsic value of A$57.20, which, compared to the current share price of A$78.04, we see that Rio Tinto is rather overvalued at the time of writing.
Next Steps:
Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For RIO, there are three key aspects you should further research:
PS. The Simply Wall St app conducts a discounted cash flow for every stock on the ASX every 6 hours. If you want to find the calculation for other stocks just search here.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.