Does This Valuation Of Reckon Limited (ASX:RKN) Imply Investors Are Overpaying?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Reckon fair value estimate is AU$0.46

• Reckon is estimated to be 34% overvalued based on current share price of AU$0.61

• Reckon's peers seem to be trading at a higher premium to fair value based onthe industry average of -114%

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Reckon Limited (ASX:RKN) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back 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.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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 Reckon

What's The Estimated Valuation?

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. In the first stage we need to estimate the cash flows to the business over the next ten years. Seeing as no analyst estimates of free cash flow are available to us, we have extrapolate the previous free cash flow (FCF) from the company's last 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$4.26m	AU$3.59m	AU$3.22m	AU$3.00m	AU$2.88m	AU$2.82m	AU$2.79m	AU$2.79m	AU$2.81m	AU$2.84m
Growth Rate Estimate Source	Est @ -23.32%	Est @ -15.70%	Est @ -10.37%	Est @ -6.63%	Est @ -4.02%	Est @ -2.19%	Est @ -0.91%	Est @ -0.01%	Est @ 0.62%	Est @ 1.05%
Present Value (A$, Millions) Discounted @ 7.1%	AU$4.0	AU$3.1	AU$2.6	AU$2.3	AU$2.0	AU$1.9	AU$1.7	AU$1.6	AU$1.5	AU$1.4

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$22m

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 (2.1%) 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 7.1%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$2.8m× (1 + 2.1%) ÷ (7.1%– 2.1%) = AU$57m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$57m÷ ( 1 + 7.1%)¹⁰= AU$29m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$51m. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of AU$0.6, 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.

ASX:RKN Discounted Cash Flow January 4th 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. 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 Reckon 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 7.1%, which is based on a levered beta of 1.013. 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 Reckon

Strength

• Debt is not viewed as a risk.

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

Weakness

• Earnings declined over the past year.

Opportunity

• Annual earnings are forecast to grow faster than the Australian market.

• Good value based on P/E ratio compared to estimated Fair P/E ratio.

Threat

• No apparent threats visible for RKN.

Next Steps:

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. 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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price exceeding the intrinsic value? For Reckon, we've put together three essential items you should assess:

1. Risks: For example, we've discovered 2 warning signs for Reckon that you should be aware of before investing here.

2. Future Earnings: How does RKN'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.