Iluka Resources Limited's (ASX:ILU) Intrinsic Value Is Potentially 36% Above Its Share Price

Key Insights

• The projected fair value for Iluka Resources is AU$9.11 based on 2 Stage Free Cash Flow to Equity

• Iluka Resources is estimated to be 27% undervalued based on current share price of AU$6.68

• Analyst price target for ILU is AU$8.28 which is 9.1% below our fair value estimate

How far off is Iluka Resources Limited (ASX:ILU) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced 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. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

See our latest analysis for Iluka Resources

The Method

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. In the first stage we need to estimate the cash flows to the business over the next ten years. 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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (A$, Millions)	-AU$437.0m	-AU$63.0m	AU$130.7m	AU$180.1m	AU$218.1m	AU$251.7m	AU$280.4m	AU$304.5m	AU$324.8m	AU$341.9m
Growth Rate Estimate Source	Analyst x2	Analyst x4	Analyst x2	Analyst x2	Est @ 21.11%	Est @ 15.40%	Est @ 11.41%	Est @ 8.61%	Est @ 6.65%	Est @ 5.28%
Present Value (A$, Millions) Discounted @ 7.5%	-AU$406	-AU$54.5	AU$105	AU$135	AU$152	AU$163	AU$169	AU$171	AU$169	AU$166

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$768m

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. 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 7.5%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$342m× (1 + 2.1%) ÷ (7.5%– 2.1%) = AU$6.4b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$6.4b÷ ( 1 + 7.5%)¹⁰= AU$3.1b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is AU$3.9b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of AU$6.7, the company appears a touch undervalued at a 27% discount to where the stock price trades currently. 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.

ASX:ILU Discounted Cash Flow December 26th 2023

The Assumptions

Now 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 Iluka Resources 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 7.5%, which is based on a levered beta of 1.087. 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 Iluka Resources

Strength

• Debt is not viewed as a risk.

Weakness

• Earnings declined over the past year.

• Dividend is low compared to the top 25% of dividend payers in the Metals and Mining market.

Opportunity

• Annual revenue is forecast to grow faster than the Australian market.

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

Threat

• Dividends are not covered by cash flow.

• Annual earnings are forecast to decline for the next 3 years.

Looking Ahead:

Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. 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. Why is the intrinsic value higher than the current share price? For Iluka Resources, we've compiled three pertinent elements you should look at:

1. Risks: To that end, you should learn about the 3 warning signs we've spotted with Iluka Resources (including 2 which don't sit too well with us) .

2. Future Earnings: How does ILU'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 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.