Today we are going to walk through a way to estimate the intrinsic value of Rottneros AB (publ) (STO:RROS) by estimating the future cash flows of the business and discounting them to their present value. Our analysis will use the discounted cash flow (DCF) model. Patterns like these may seem beyond a layman’s comprehension, but they’re pretty easy to follow.
Businesses can be valued in many ways, which is why we emphasize that a DCF is not perfect for all situations. Anyone interested in learning a little more about intrinsic value should read the Simply Wall St.
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What is the estimated valuation?
We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “sustained growth”. In the first step, we need to estimate the company’s cash flow over 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, and so the sum of these future cash flows is then discounted to today’s value:
10-Year Free Cash Flow (FCF) Forecast
|Leveraged FCF (SEK, millions)||kr158.0 million||kr195.0 million||kr179.0 million||169.3 million kr||163.1 million kr||kr159.0 million||156.4 million kr||154.7 million kr||153.7 million kr||153.2 million kr|
|Growth rate estimate Source||Analyst x1||Analyst x1||Analyst x1||Is @ -5.41%||East @ -3.69%||Is @ -2.49%||Is @ -1.65%||Is @ -1.06%||Is @ -0.65%||Is @ -0.36%|
|Present value (SEK, million) discounted at 6.2%||149 kr||173 kr||149 kr||133 kr||121 kr||111 kr||103kr||95.6kr||89.4kr||83.9kr|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = kr1.2b
After calculating the present value of future cash flows over the initial 10-year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 0.3%. We discount terminal cash flows to present value at a cost of equity of 6.2%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = kr153m × (1 + 0.3%) ÷ (6.2%– 0.3%) = kr2.6b
Present value of terminal value (PVTV)= TV / (1 + r)ten= kr2.6b÷ ( 1 + 6.2%)ten= kr1.4b
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is 2.6 billion kr. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of 12.3 kr, the company looks slightly undervalued at a 29% discount to the current share price. Ratings are imprecise instruments, however, much like a telescope – move a few degrees and end up in a different galaxy. Keep that in mind.
The above calculation is highly dependent on two assumptions. One is the discount rate and the other is the cash flows. If you disagree with these results, try the math yourself and play around with the assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Rottneros 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 6.2%, which is based on a leveraged beta of 1.391. 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.
Although a business valuation is important, it is only one of many factors you need to assess for a business. The DCF model is not a perfect stock valuation tool. 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 the stock price below intrinsic value? For Rottneros, there are three essential aspects that you should delve into:
- Risks: Take risks, for example – Rottneros has 3 warning signs (and 1 which is significant) that we think you should know about.
- Future earnings: How does RROS’ growth rate 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.
- 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 companies you may not have considered!
PS. Simply Wall St updates its DCF calculation for every Swedish stock daily, so if you want to find the intrinsic value of any other stock, 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.