Is There An Opportunity With Rentokil Initial plc's (LON:RTO) 42% Undervaluation?

Simply Wall St · 10/17 07:50

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, Rentokil Initial fair value estimate is UK£5.88
  • Rentokil Initial's UK£3.41 share price signals that it might be 42% undervalued
  • Analyst price target for RTO is UK£4.64 which is 21% below our fair value estimate

How far off is Rentokil Initial plc (LON:RTO) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the forecast future cash flows of the company and discounting them back to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. 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.

See our latest analysis for Rentokil Initial

The 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

2025 2026 2027 2028 2029 2030 2031 2032 2033 2034
Levered FCF (£, Millions) UK£607.4m UK£694.2m UK£804.0m UK£860.0m UK£902.2m UK£938.4m UK£970.2m UK£998.8m UK£1.03b UK£1.05b
Growth Rate Estimate Source Analyst x4 Analyst x4 Analyst x1 Analyst x1 Est @ 4.90% Est @ 4.01% Est @ 3.39% Est @ 2.95% Est @ 2.64% Est @ 2.43%
Present Value (£, Millions) Discounted @ 7.7% UK£564 UK£599 UK£644 UK£640 UK£624 UK£603 UK£579 UK£554 UK£528 UK£502

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£5.8b

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 7.7%.

Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = UK£1.1b× (1 + 1.9%) ÷ (7.7%– 1.9%) = UK£19b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£19b÷ ( 1 + 7.7%)10= UK£8.9b

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£15b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of UK£3.4, the company appears quite undervalued at a 42% 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.

dcf
LSE:RTO Discounted Cash Flow October 17th 2024

Important 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 Rentokil Initial 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 7.7%, which is based on a levered beta of 1.181. 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 Rentokil Initial

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

Moving On:

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. DCF models are not the be-all and end-all of investment valuation. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or 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. Why is the intrinsic value higher than the current share price? For Rentokil Initial, we've compiled three important items you should look at:

  1. Risks: For example, we've discovered 3 warning signs for Rentokil Initial (1 is a bit concerning!) that you should be aware of before investing here.
  2. Future Earnings: How does RTO'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. Simply Wall St updates its DCF calculation for every British stock every day, so if you want to find the intrinsic value of any other stock just search here.