Is There An Opportunity With Sierra Rutile Holdings Limited's (ASX:SRX) 37% Undervaluation?
Key Insights
The projected fair value for Sierra Rutile Holdings is AU$0.37 based on 2 Stage Free Cash Flow to Equity
Sierra Rutile Holdings' AU$0.23 share price signals that it might be 37% undervalued
Does the March share price for Sierra Rutile Holdings Limited (ASX:SRX) reflect what it's really worth? Today, we will estimate the stock's intrinsic value by estimating the company's future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model on this occasion. There's really not all that much to it, even though it might appear quite complex.
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
See our latest analysis for Sierra Rutile Holdings
The Method
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:
10-year free cash flow (FCF) forecast
2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | |
Levered FCF ($, Millions) | US$34.9m | -US$75.7m | -US$83.2m | -US$25.8m | US$8.00m | US$11.6m | US$15.4m | US$19.0m | US$22.2m | US$24.9m |
Growth Rate Estimate Source | Analyst x2 | Analyst x2 | Analyst x2 | Analyst x1 | Analyst x1 | Est @ 45.44% | Est @ 32.39% | Est @ 23.25% | Est @ 16.85% | Est @ 12.38% |
Present Value ($, Millions) Discounted @ 8.6% | US$32.1 | -US$64.3 | -US$65.1 | -US$18.6 | US$5.3 | US$7.1 | US$8.7 | US$9.8 | US$10.6 | US$11.0 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = -US$63m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (1.9%) 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 8.6%.
Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$25m× (1 + 1.9%) ÷ (8.6%– 1.9%) = US$383m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$383m÷ ( 1 + 8.6%)10= US$169m
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$105m. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of AU$0.2, the company appears quite good value at a 37% discount to where the stock price trades currently. 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.
The Assumptions
We would point out that 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 Sierra Rutile Holdings 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 8.6%, which is based on a levered beta of 1.116. 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.
Next Steps:
Whilst important, the DCF calculation is only one of many factors that you need to assess for 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. What is the reason for the share price sitting below the intrinsic value? For Sierra Rutile Holdings, we've compiled three further aspects you should explore:
Risks: Be aware that Sierra Rutile Holdings is showing 2 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...
Future Earnings: How does SRX'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.
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 Australian 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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