Estimating The Intrinsic Value Of RWE Aktiengesellschaft (ETR:RWE)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, RWE fair value estimate is €34.06

• With €40.60 share price, RWE appears to be trading close to its estimated fair value

• Our fair value estimate is 35% lower than RWE's analyst price target of €52.48

Today we will run through one way of estimating the intrinsic value of RWE Aktiengesellschaft (ETR:RWE) by taking the forecast future cash flows of the company and discounting them back to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

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 RWE

Crunching The Numbers

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. To start off with, we need to estimate 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (€, Millions)	€928.5m	€1.03b	€1.09b	€1.15b	€1.18b	€1.21b	€1.23b	€1.25b	€1.26b	€1.27b
Growth Rate Estimate Source	Analyst x4	Analyst x3	Est @ 6.56%	Est @ 4.67%	Est @ 3.34%	Est @ 2.41%	Est @ 1.76%	Est @ 1.30%	Est @ 0.98%	Est @ 0.76%
Present Value (€, Millions) Discounted @ 5.0%	€884	€932	€946	€943	€928	€905	€877	€846	€814	€781

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = €8.9b

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. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (0.2%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 5.0%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = €1.3b× (1 + 0.2%) ÷ (5.0%– 0.2%) = €27b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= €27b÷ ( 1 + 5.0%)¹⁰= €16b

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 €25b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of €40.6, the company appears around fair value 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.

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 RWE 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 5.0%, which is based on a levered beta of 0.800. 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 RWE

Strength

• Net debt to equity ratio below 40%.

Weakness

• Earnings growth over the past year underperformed the Renewable Energy industry.

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

• Shareholders have been diluted in the past year.

Opportunity

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

Threat

• Debt is not well covered by operating cash flow.

• Paying a dividend but company has no free cash flows.

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

Moving On:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching 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 example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For RWE, there are three important aspects you should further examine:

1. Risks: To that end, you should learn about the 4 warning signs we've spotted with RWE (including 2 which shouldn't be ignored) .

2. Future Earnings: How does RWE'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 High Quality Alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the XTRA 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.

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