Estimating The Intrinsic Value Of Rotork plc (LON:ROR)

Simply Wall St · 09/28 07:03

Key Insights

  • The projected fair value for Rotork is UK£3.34 based on 2 Stage Free Cash Flow to Equity
  • With UK£3.39 share price, Rotork appears to be trading close to its estimated fair value
  • Our fair value estimate is 7.8% lower than Rotork's analyst price target of UK£3.62

In this article we are going to estimate the intrinsic value of Rotork plc (LON:ROR) by taking the expected future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. There's really not all that much to it, even though it might appear quite complex.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Rotork

The Method

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. 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

2025 2026 2027 2028 2029 2030 2031 2032 2033 2034
Levered FCF (£, Millions) UK£122.9m UK£133.1m UK£138.2m UK£142.7m UK£146.8m UK£150.6m UK£154.2m UK£157.7m UK£161.1m UK£164.5m
Growth Rate Estimate Source Analyst x6 Analyst x5 Est @ 3.84% Est @ 3.27% Est @ 2.87% Est @ 2.59% Est @ 2.39% Est @ 2.25% Est @ 2.16% Est @ 2.09%
Present Value (£, Millions) Discounted @ 6.7% UK£115 UK£117 UK£114 UK£110 UK£106 UK£102 UK£97.7 UK£93.6 UK£89.5 UK£85.6

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£1.0b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (1.9%) 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 6.7%.

Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = UK£164m× (1 + 1.9%) ÷ (6.7%– 1.9%) = UK£3.5b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£3.5b÷ ( 1 + 6.7%)10= UK£1.8b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is UK£2.8b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of UK£3.4, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

dcf
LSE:ROR Discounted Cash Flow September 28th 2024

The Assumptions

We would point out 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 evaluation of a company's future performance, so try the calculation yourself and check your own assumptions. 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 Rotork 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 6.7%, which is based on a levered beta of 0.993. 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 Rotork

Strength
  • Earnings growth over the past year exceeded the industry.
  • Debt is not viewed as a risk.
  • Dividends are covered by earnings and cash flows.
Weakness
  • Dividend is low compared to the top 25% of dividend payers in the Machinery market.
  • Expensive based on P/E ratio and estimated fair value.
Opportunity
  • Annual revenue is forecast to grow faster than the British market.
Threat
  • Annual earnings are forecast to grow slower than the British market.

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching 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. For Rotork, we've put together three additional aspects you should assess:

  1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Rotork , and understanding it should be part of your investment process.
  2. Future Earnings: How does ROR'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.
  3. 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 LSE every day. If you want to find the calculation for other stocks just search here.