Does This Valuation Of Rio Tinto Group (LON:RIO) Imply Investors Are Overpaying?

Key Insights

• Rio Tinto Group's estimated fair value is UK£37.05 based on 2 Stage Free Cash Flow to Equity

• Rio Tinto Group's UK£48.40 share price signals that it might be 31% overvalued

• Analyst price target for RIO is US$60.50, which is 63% above our fair value estimate

How far off is Rio Tinto Group (LON:RIO) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by estimating the company's 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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

View our latest analysis for Rio Tinto Group

The Method

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. 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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	US$8.08b	US$6.99b	US$7.90b	US$6.45b	US$6.23b	US$6.10b	US$6.04b	US$6.02b	US$6.02b	US$6.05b
Growth Rate Estimate Source	Analyst x13	Analyst x13	Analyst x9	Analyst x2	Est @ -3.42%	Est @ -2.02%	Est @ -1.04%	Est @ -0.36%	Est @ 0.12%	Est @ 0.46%
Present Value ($, Millions) Discounted @ 9.2%	US$7.4k	US$5.9k	US$6.1k	US$4.5k	US$4.0k	US$3.6k	US$3.3k	US$3.0k	US$2.7k	US$2.5k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$43b

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 1.2%. We discount the terminal cash flows to today's value at a cost of equity of 9.2%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$6.1b× (1 + 1.2%) ÷ (9.2%– 1.2%) = US$77b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$77b÷ ( 1 + 9.2%)¹⁰= US$32b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$74b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of UK£48.4, the company appears potentially overvalued 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

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Rio Tinto Group 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 9.2%, which is based on a levered beta of 1.149. 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 Rio Tinto Group

Strength

• Debt is not viewed as a risk.

• Dividends are covered by earnings and cash flows.

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

Weakness

• Earnings declined over the past year.

Opportunity

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

Threat

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

Looking Ahead:

Valuation is only one side of the coin in terms of building your investment thesis, and it 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. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price exceeding the intrinsic value? For Rio Tinto Group, we've compiled three important elements you should look at:

1. Risks: For example, we've discovered 3 warning signs for Rio Tinto Group (1 is concerning!) that you should be aware of before investing here.

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for RIO's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

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 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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