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Red 5 Limited's (ASX:RED) Intrinsic Value Is Potentially 95% Above Its Share Price

Key Insights

  • The projected fair value for Red 5 is AU$0.58 based on 2 Stage Free Cash Flow to Equity

  • Red 5 is estimated to be 49% undervalued based on current share price of AU$0.29

  • Analyst price target for RED is AU$0.35 which is 39% below our fair value estimate

How far off is Red 5 Limited (ASX:RED) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced 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.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

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See our latest analysis for Red 5

Crunching The Numbers

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. 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 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$71.2m

AU$95.7m

AU$108.8m

AU$118.5m

AU$126.6m

AU$133.5m

AU$139.4m

AU$144.6m

AU$149.3m

AU$153.6m

Growth Rate Estimate Source

Analyst x2

Analyst x2

Analyst x2

Est @ 8.91%

Est @ 6.86%

Est @ 5.43%

Est @ 4.42%

Est @ 3.72%

Est @ 3.23%

Est @ 2.88%

Present Value (A$, Millions) Discounted @ 8.1%

AU$65.9

AU$81.9

AU$86.2

AU$86.9

AU$85.9

AU$83.8

AU$80.9

AU$77.7

AU$74.2

AU$70.6

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$794m

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 8.1%.

Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = AU$154m× (1 + 2.1%) ÷ (8.1%– 2.1%) = AU$2.6b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$2.6b÷ ( 1 + 8.1%)10= AU$1.2b

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$2.0b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of AU$0.3, the company appears quite undervalued at a 49% 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

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Red 5 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 8.1%, which is based on a levered beta of 1.199. 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 Red 5

Strength

  • Debt is well covered by cash flow.

Weakness

  • Interest payments on debt are not well covered.

  • Shareholders have been diluted in the past year.

Opportunity

  • Expected to breakeven next year.

  • Has sufficient cash runway for more than 3 years based on current free cash flows.

  • Trading below our estimate of fair value by more than 20%.

Threat

  • No apparent threats visible for RED.

Looking Ahead:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize 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?" 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 Red 5, we've compiled three further items you should look at:

  1. Risks: Be aware that Red 5 is showing 1 warning sign in our investment analysis , you should know about...

  2. Future Earnings: How does RED'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.

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.