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Is Royal Mail plc (LON:RMG) Trading At A 37% Discount?

Does the September share price for Royal Mail plc (LON:RMG) reflect what it’s really worth? Today, we will estimate the stock’s intrinsic value by projecting its future cash flows and then discounting them to today’s value. We will take advantage of th…

Does the September share price for Royal Mail plc (LON:RMG) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by projecting its future cash flows and then discounting them to today's 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. 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.

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 Royal Mail

Crunching the numbers

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase.

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. A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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

2022

2023

2024

2025

2026

2027

2028

2029

2030

2031

Levered FCF (GBP, Millions)

UKGBP664.1m

UKGBP448.0m

UKGBP550.4m

UKGBP592.0m

UKGBP529.0m

UKGBP492.1m

UKGBP469.5m

UKGBP455.7m

UKGBP447.5m

UKGBP443.2m

Growth Rate Estimate Source

Analyst x3

Analyst x5

Analyst x5

Analyst x1

Analyst x1

Est @ -6.97%

Est @ -4.6%

Est @ -2.94%

Est @ -1.79%

Est @ -0.97%

Present Value (GBP, Millions) Discounted @ 6.7%

UKGBP623

UKGBP394

UKGBP454

UKGBP458

UKGBP383

UKGBP334

UKGBP299

UKGBP272

UKGBP251

UKGBP233

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UKGBP3.7b Story continues

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 (0.9%) 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)= FCF2031 x (1 + g) / (r - g) = UKGBP443mx (1 + 0.9%) / (6.7%- 0.9%) = UKGBP7.8b Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UKGBP7.8b/ ( 1 + 6.7%)10= UKGBP4.1b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is UKGBP7.8b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of UKGBP4.9, the company appears quite undervalued at a 37% discount to where the stock price trades currently.

The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf

dcf

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. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Royal Mail 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 1.080. 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.

Moving On:

Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation.

What is the reason for the share price sitting below the intrinsic value? For Royal Mail, we've compiled three further aspects you should assess:

  1. Risks: Take risks, for example - Royal Mail has 2 warning signs we think you should be aware of.

  2. Future Earnings: How does RMG'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.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

Simply Wall St has no position in any stocks mentioned.

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