Today we are going to do a simple overview of a valuation method used to estimate the attractiveness of Response Plus Holding PJSC (ADX:RPM) as an investment opportunity by taking cash flow expected future of the business and discounting them to today’s value. Our analysis will use the discounted cash flow (DCF) model. This may sound complicated, but it’s actually quite simple!
Businesses can be valued in many ways, which is why we emphasize that a DCF is not perfect for all situations. If you want to know more about discounted cash flows, the rationale for this calculation can be read in detail in the Simply Wall St Analysis Template.
See our latest analysis for Response Plus Holding PJSC
Is Response Plus Holding PJSC valued at fair value?
We use what is called a 2-step model, which simply means that we have two different periods of company cash flow growth rates. Generally, the first stage is a higher growth phase and the second stage is a lower growth phase. To begin with, we need to obtain cash flow estimates for the next ten years. Since no analyst estimate of free cash flow is available, we have extrapolated the previous free cash flow (FCF) from the company’s latest reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we need to discount the sum of these future cash flows to arrive at an estimate of present value:
Estimated free cash flow (FCF) over 10 years
|Leveraged FCF (AED, Millions)||د.إ63.4m||Ï.å70.2m||د.إ77.4m||Ï.å85.0m||د.إ93.2m||د.إ101.9m||د.إ111.4m||د.إ121.6m||د.إ132.7m||د.إ144.7m|
|Growth rate estimate Source||Is at 11.58%||Is at 10.8%||Is at 10.25%||Is 9.86%||Is at 9.59%||Is at 9.4%||Is at 9.27%||Is at 9.18%||Is at 9.11%||Is at 9.07%|
|Present value (AED, millions) discounted at 13%||Ï.å56.1||د.إ55.0||د.إ53.7||Ï.å52.3||Ï.å50.7||Ï.å49.1||د.إ47.5||د.إ45.9||د.إ44.4||د.إ42.9|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = د.إ497m
After calculating the present value of future cash flows over the initial 10-year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 9.0%. We discount terminal cash flows to present value at a cost of equity of 13%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = Ï.å145m× (1 + 9.0%) ÷ (13%– 9.0%) = ï.å4.0b
Present value of terminal value (PVTV)= TV / (1 + r)ten= Ï.å4.0b÷ ( 1 + 13%)ten= Ï.å1.2b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is Ï,å1.7b. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of د.إ9.0, the company appears around fair value at the time of writing. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.
We emphasize 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 entries, I recommend that you redo the calculations yourself and play around with them. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we are considering Response Plus Holding PJSC 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 takes into account the debt. In this calculation, we used 13%, which is based on a leveraged beta of 0.840. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Valuation is only one side of the coin in terms of crafting your investment thesis, and it shouldn’t be the only metric you look at when researching a company. It is not possible to obtain an infallible valuation with a DCF model. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. If a company grows at a different pace, or if its cost of equity or risk-free rate changes sharply, output may be very different. For Response Plus Holding PJSC, there are three important things you need to consider:
- Risks: You should be aware of the 2 warning signs for Response Plus Holding PJSC we found out before considering an investment in the business.
- Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of what you might be missing!
- Other top analyst picks: Interested to see what the analysts think? Take a look at our interactive list of analysts’ top stock picks to find out what they think could have attractive future prospects!
PS. Simply Wall St updates its DCF calculation for every UAE stock daily, so if you want to find the intrinsic value of any other stock, just search here.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.