Are Deterra Royalties Limited (ASX:DRR) Investors Paying Above The Intrinsic Value?

Key Insights

• The projected fair value for Deterra Royalties is AU$3.32 based on 2 Stage Free Cash Flow to Equity

• Current share price of AU$4.47 suggests Deterra Royalties is potentially 35% overvalued

• Analyst price target for DRR is AU$4.58, which is 38% above our fair value estimate

Today we will run through one way of estimating the intrinsic value of Deterra Royalties Limited (ASX:DRR) by taking the expected future cash flows and discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.

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.

View our latest analysis for Deterra Royalties

What's The Estimated Valuation?

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 start off with, we need to estimate 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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	AU$153.2m	AU$150.3m	AU$136.5m	AU$115.7m	AU$109.0m	AU$105.3m	AU$103.4m	AU$102.7m	AU$102.9m	AU$103.6m
Growth Rate Estimate Source	Analyst x5	Analyst x5	Analyst x2	Analyst x2	Est @ -5.77%	Est @ -3.44%	Est @ -1.80%	Est @ -0.66%	Est @ 0.14%	Est @ 0.70%
Present Value (A$, Millions) Discounted @ 7.6%	AU$142	AU$130	AU$110	AU$86.4	AU$75.7	AU$68.0	AU$62.1	AU$57.3	AU$53.4	AU$50.0

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$835m

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 7.6%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$104m× (1 + 2.0%) ÷ (7.6%– 2.0%) = AU$1.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$1.9b÷ ( 1 + 7.6%)¹⁰= AU$918m

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is AU$1.8b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of AU$4.5, the company appears potentially overvalued at the time of writing. 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

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. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Deterra Royalties 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 7.6%, which is based on a levered beta of 1.111. 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 Deterra Royalties

Strength

• Earnings growth over the past year exceeded the industry.

• Currently debt free.

• Dividend is in the top 25% of dividend payers in the market.

Weakness

• Expensive based on P/E ratio and estimated fair value.

Opportunity

• DRR's financial characteristics indicate limited near-term opportunities for shareholders.

Threat

• Dividends are not covered by earnings and cashflows.

• Annual earnings are forecast to decline for the next 4 years.

Moving On:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for 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. Can we work out why the company is trading at a premium to intrinsic value? For Deterra Royalties, we've compiled three important factors you should further research:

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

2. Future Earnings: How does DRR'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 Australian stock every day, so if you want to find the intrinsic value of any other stock just search here.

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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.