A Look At The Fair Value Of RF Industries, Ltd. (NASDAQ:RFIL)

Key Insights

• RF Industries' estimated fair value is US$4.55 based on 2 Stage Free Cash Flow to Equity

• RF Industries' US$4.21 share price indicates it is trading at similar levels as its fair value estimate

• The average premium for RF Industries' competitorsis currently 28%

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of RF Industries, Ltd. (NASDAQ:RFIL) as an investment opportunity by taking the expected future cash flows and discounting them 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.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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 RF Industries

The Method

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 begin with, we have to get estimates of 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.

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) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	US$3.37m	US$3.73m	US$3.99m	US$4.21m	US$4.40m	US$4.56m	US$4.71m	US$4.85m	US$4.98m	US$5.10m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ 7.01%	Est @ 5.53%	Est @ 4.49%	Est @ 3.77%	Est @ 3.26%	Est @ 2.90%	Est @ 2.65%	Est @ 2.48%
Present Value ($, Millions) Discounted @ 11%	US$3.0	US$3.0	US$2.9	US$2.8	US$2.6	US$2.5	US$2.3	US$2.1	US$2.0	US$1.8

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$25m

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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 11%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$5.1m× (1 + 2.1%) ÷ (11%– 2.1%) = US$60m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$60m÷ ( 1 + 11%)¹⁰= US$22m

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$47m. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$4.2, the company appears about fair value at a 7.4% 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

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 RF Industries 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 1.461. 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 RF Industries

Strength

• Debt is not viewed as a risk.

Weakness

• Earnings declined over the past year.

• Shareholders have been diluted in the past year.

Opportunity

• Annual earnings are forecast to grow faster than the American market.

• Current share price is below our estimate of fair value.

Threat

• No apparent threats visible for RFIL.

Next Steps:

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. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/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. For RF Industries, there are three relevant factors you should explore:

1. Risks: For instance, we've identified 4 warning signs for RF Industries that you should be aware of.

2. Future Earnings: How does RFIL'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 NASDAQGM 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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