Is There An Opportunity With Red Robin Gourmet Burgers, Inc.'s (NASDAQ:RRGB) 29% Undervaluation?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Red Robin Gourmet Burgers fair value estimate is US$8.99

• Red Robin Gourmet Burgers' US$6.40 share price signals that it might be 29% undervalued

• Analyst price target for RRGB is US$13.25, which is 47% above our fair value estimate

In this article we are going to estimate the intrinsic value of Red Robin Gourmet Burgers, Inc. (NASDAQ:RRGB) by taking the expected future cash flows and discounting them to their present value. This will be done using the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. 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 Red Robin Gourmet Burgers

Step By Step Through The Calculation

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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	US$15.0m	US$14.4m	US$14.2m	US$14.1m	US$14.1m	US$14.2m	US$14.4m	US$14.6m	US$14.9m	US$15.2m
Growth Rate Estimate Source	Analyst x1	Est @ -3.76%	Est @ -1.94%	Est @ -0.67%	Est @ 0.21%	Est @ 0.84%	Est @ 1.27%	Est @ 1.58%	Est @ 1.79%	Est @ 1.94%
Present Value ($, Millions) Discounted @ 11%	US$13.5	US$11.6	US$10.2	US$9.1	US$8.2	US$7.4	US$6.7	US$6.1	US$5.6	US$5.1

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$84m

The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. 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 2.3%. We discount the terminal cash flows to today's value at a cost of equity of 11%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$15m× (1 + 2.3%) ÷ (11%– 2.3%) = US$169m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$169m÷ ( 1 + 11%)¹⁰= US$57m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$140m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$6.4, the company appears a touch undervalued at a 29% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

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. 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 Red Robin Gourmet Burgers 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 11%, which is based on a levered beta of 2.000. 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 Robin Gourmet Burgers

Strength

• Debt is well covered by earnings.

Weakness

• No major weaknesses identified for RRGB.

Opportunity

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

Threat

• Debt is not well covered by operating cash flow.

• Has less than 3 years of cash runway based on current free cash flow.

• Total liabilities exceed total assets, which raises the risk of financial distress.

• Not expected to become profitable over the next 3 years.

Moving On:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. 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. Why is the intrinsic value higher than the current share price? For Red Robin Gourmet Burgers, we've compiled three pertinent elements you should consider:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 4 warning signs with Red Robin Gourmet Burgers , and understanding these should be part of your investment process.

2. Future Earnings: How does RRGB'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 American 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.