Estimating The Intrinsic Value Of Rentokil Initial plc (LON:RTO)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Rentokil Initial fair value estimate is UK£4.97

• Rentokil Initial's UK£5.11 share price indicates it is trading at similar levels as its fair value estimate

• Analyst price target for RTO is UK£5.79, which is 16% above our fair value estimate

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Rentokil Initial plc (LON:RTO) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

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.

See our latest analysis for Rentokil Initial

Step By Step Through The Calculation

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 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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF (£, Millions)	UK£525.6m	UK£639.1m	UK£650.7m	UK£802.0m	UK£876.9m	UK£937.2m	UK£985.6m	UK£1.02b	UK£1.06b	UK£1.08b
Growth Rate Estimate Source	Analyst x9	Analyst x8	Analyst x3	Analyst x1	Est @ 9.34%	Est @ 6.88%	Est @ 5.16%	Est @ 3.96%	Est @ 3.12%	Est @ 2.53%
Present Value (£, Millions) Discounted @ 8.2%	UK£486	UK£546	UK£514	UK£585	UK£591	UK£584	UK£568	UK£545	UK£520	UK£492

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£5.4b

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 (1.2%) 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 8.2%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = UK£1.1b× (1 + 1.2%) ÷ (8.2%– 1.2%) = UK£16b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£16b÷ ( 1 + 8.2%)¹⁰= UK£7.1b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is UK£12b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of UK£5.1, the company appears around fair value at the time of writing. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

dcf

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. 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 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 8.2%, which is based on a levered beta of 1.012. 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 its 5-year average.

• Debt is well covered by earnings.

Weakness

• Earnings growth over the past year underperformed the Commercial Services industry.

• Dividend is low compared to the top 25% of dividend payers in the Commercial Services market.

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

• Shareholders have been diluted in the past year.

Opportunity

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

Threat

• Debt is not well covered by operating cash flow.

• Revenue is forecast to grow slower than 20% per year.

Looking Ahead:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/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. For Rentokil Initial, there are three relevant factors you should consider:

1. Risks: For example, we've discovered 2 warning signs for Rentokil Initial (1 doesn't sit too well with us!) 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 High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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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