With so many different financial models generating different conclusions, choosing the most relevant one to value a company can be daunting. A prime example of conflicts between valuation models is RPM International Inc’s (NYSE:RPM). While my discounted cash flow (DCF) model tells me that it is undervalued by 18.2%, my relative valuation model says it is overvalued by 55.42%. So, which valuation methodology should I listen to and why?
Deep-dive into intrinsic valuation
Forecasting anything into the distant future is difficult and the same applies to forecasting free cash flows (FCFs) for businesses. This is why I’ve decided to use analyst FCF forecasts in my DCF to see what the consensus view is while also removing some subjectivity. If you’re unfamiliar with valuation, the assumption behind every DCF is that a firm’s true value is derived from the sum of all its future FCFs, which is why quality forecasts are important. After discounting the sum of RPM’s future FCFs by 12%, it’s equity value comes to $US$7.1b, then 132.72k shares outstanding are divided through. This results in an intrinsic value of $53.42. Check out the source of my intrinsic value here.,
But how dependable is this value? A key assumption in DCFs is that by the final year of our forecast horizon, which is year 5 in RPM’s case, a company is assumed to be mature and therefore FCF should be growing at a sustainable rate. At -6.21%, final year FCF growth is unsustainably low. If this assumption held true, RPM would shrink to a point where it would cease to exist very soon, which is a highly unlikely outcome. Since these assumptions are far too extreme and unrealistic, one way of improving our DCF is to extend our forecast horizon by another few years until FCF growth moderates to a more sustainable rate. However, the trade-off is that there are less analyst forecasts the further in the future we go.
Examining relative valuation
Unlike the DCF model, relative valuation is based on a different principle and therefore, has its own set of issues. The underlying assumption is that two companies with the same risk-return profiles should be priced identically. The hardest part; however, is finding companies that are similar to RPM. As such, I’ve used the Chemicals industry as a proxy for RPM. To calculate the “true” value of RPM, we multiply RPM’s earnings by the industry’s P/E ratio to obtain a share price of $28.15, which means RPM is overvalued. But is this a dependable conclusion?
To check the robustness of our relative valuation, let’s take a look at if RPM has a similar growth profile to the overall Chemicals industry. With a projected earnings growth rate of 30.05% for next year, RPM has a significantly different growth profile when compared with the Chemicals industry, which is projected to grow at 22.07%. This demonstrates that the Chemicals industry is a weak proxy for RPM, which undermines our relative valuation analysis. Instead, we could dramatically improve our analysis by hand-picking companies that share similar growth profiles with RPM. I’d encourage you to do this by taking a look at RPM’s competitors.
Which Model Should I Care About?
Both are somewhat weakened by assumptions we have used to fill in the gaps. Relative valuation is computationally simple but exposed to market irrationality, which undermines its usefulness. Conversely, intrinsic valuation is immune from these factors but heavily affected by human forecasting errors. Given the pros and cons that I have laid out, I encourage you to derive a valuation by calculating a weighted average share price by using both models.
For RPM, I’ve put together three fundamental aspects you should further examine:
- Financial Health: Does RPM have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does RPM’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 High Quality Alternatives: Are there other high quality stocks you could be holding instead of RPM? 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 for every stock on the NYSE every 6 hours. If you want to find the calculation for other stocks just search here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.