An intrinsic calculation for RPS Group plc (LON:RPS) suggests it is undervalued by 50%


In this article, we will estimate the intrinsic value of RPS Group plc (LON: RPS) by projecting its future cash flows and then discounting them to their present value. This will be done using the discounted cash flow (DCF) model. Before you think you can’t figure it out, just read on! It’s actually a lot less complex than you might imagine.

Businesses can be valued in many ways, which is why we emphasize that a DCF is not perfect for all situations. If you still have burning questions about this type of assessment, take a look at the Simply Wall St Analysis Template.

Check out our latest analysis for RPS Group

The model

We use what is called a 2-stage model, which simply means that we have two different periods of company cash flow growth rates. Generally, the first stage is a higher growth phase and the second stage is a lower growth phase. To start, we need to estimate the cash flows for the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported 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 more in early years than in later years.

Generally, we assume that a dollar today is worth more 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

2022

2023

2024

2025

2026

2027

2028

2029

2030

2031

Leveraged FCF (£, millions)

-UK£19.0m

UK£17.4m

UK£21.8m

UK£25.1m

UK£27.8m

UK£29.9m

UK£31.6m

UK£32.9m

UK£34.0m

UK£34.9m

Growth rate estimate Source

Analyst x2

Analyst x3

Analyst x3

Is at 14.85%

Is at 10.66%

Is at 7.73%

Is at 5.67%

Is at 4.24%

East @ 3.23%

Is at 2.52%

Present value (£, million) discounted at 6.0%

-UK£17.9

UK£15.5

UK£18.3

UK£19.8

UK£20.7

UK£21.0

UK£21.0

UK£20.6

UK£20.1

UK£19.4

(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = UK £158 million

The second stage is also known as the terminal value, it is the cash flow of the business after the first stage. For a number of reasons, a very conservative growth rate is used which cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (0.9%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 6.0%.

Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = £35 million × (1 + 0.9%) ÷ (6.0%–0.9%) = £682 million

Present value of terminal value (PVTV)= TV / (1 + r)ten= UK £682 million ÷ (1 + 6.0%)ten= UK £379 million

The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is £537 million. The final step is to divide the equity value by the number of shares outstanding. Compared to the current share price of £1.0 in the UK, the company appears to be pretty good value at a 50% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.

dcf

The hypotheses

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 entries, I recommend you redo the calculations yourself and play around with them. The DCF also does not take into account the possible cyclicality of an industry, nor the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider RPS Group 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 takes debt into account. In this calculation, we used 6.0%, which is based on a leveraged beta of 1.066. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

Let’s move on :

While important, calculating DCF shouldn’t be the only metric to consider when researching a business. It is not possible to obtain an infallible valuation with a DCF model. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on the valuation. Why is intrinsic value higher than the current stock price? For RPS Group, there are three other elements to consider:

  1. Risks: You should be aware of the 1 warning sign for the RPS group we found out before considering an investment in the business.

  2. Future earnings: How does the growth rate of RPS compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.

  3. Other strong companies: Low debt, high returns on equity and good past performance are essential to a strong business. Why not explore our interactive list of stocks with strong trading fundamentals to see if there are any other businesses you may not have considered!

PS. The Simply Wall St app performs an updated cash flow valuation for every stock on the LSE every day. If you want to find the calculation for other stocks just search here.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.