Are Redrow plc (LON:RDW) Investors Paying Above The Intrinsic Value?

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Redrow fair value estimate is UK£4.37

• Redrow's UK£5.87 share price signals that it might be 34% overvalued

• The UK£6.18 analyst price target for RDW is 41% more than our estimate of fair value

In this article we are going to estimate the intrinsic value of Redrow plc (LON:RDW) by estimating the company's future cash flows and discounting them to their present value. One way to achieve this is by employing 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.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Redrow

The Model

We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (£, Millions)	UK£28.9m	UK£91.2m	UK£71.7m	UK£87.0m	UK£98.2m	UK£107.6m	UK£115.2m	UK£121.5m	UK£126.7m	UK£131.0m
Growth Rate Estimate Source	Analyst x5	Analyst x6	Analyst x5	Analyst x1	Est @ 12.92%	Est @ 9.50%	Est @ 7.11%	Est @ 5.43%	Est @ 4.26%	Est @ 3.44%
Present Value (£, Millions) Discounted @ 8.7%	UK£26.6	UK£77.2	UK£55.8	UK£62.3	UK£64.8	UK£65.3	UK£64.3	UK£62.4	UK£59.8	UK£56.9

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£595m

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. 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 1.5%. We discount the terminal cash flows to today's value at a cost of equity of 8.7%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£131m× (1 + 1.5%) ÷ (8.7%– 1.5%) = UK£1.9b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£1.9b÷ ( 1 + 8.7%)¹⁰= UK£806m

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is UK£1.4b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of UK£5.9, the company appears reasonably expensive at the time of writing. 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.

LSE:RDW Discounted Cash Flow January 12th 2024

Important 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 Redrow 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 8.7%, which is based on a levered beta of 1.213. 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 Redrow

Strength

• Earnings growth over the past year exceeded the industry.

• Currently debt free.

• Dividends are covered by earnings and cash flows.

Weakness

• Dividend is low compared to the top 25% of dividend payers in the Consumer Durables market.

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:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. What is the reason for the share price exceeding the intrinsic value? For Redrow, there are three essential elements you should explore:

1. Risks: We feel that you should assess the 2 warning signs for Redrow (1 makes us a bit uncomfortable!) we've flagged before making an investment in the company.

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for RDW'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the LSE every day. If you want to find the calculation for other stocks 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.