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Is Rent-A-Center, Inc. (NASDAQ:RCII) Trading At A 44% Discount?

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Rent-A-Center, Inc. (NASDAQ:RCII) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. It may sound complicated, but actually it is quite simple!

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

View our latest analysis for Rent-A-Center

The Model

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 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, 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$205.9m

US$233.3m

US$203.0m

US$218.0m

US$219.7m

US$222.3m

US$225.4m

US$228.9m

US$232.8m

US$236.9m

Growth Rate Estimate Source

Analyst x2

Analyst x2

Analyst x1

Analyst x1

Est @ 0.79%

Est @ 1.15%

Est @ 1.40%

Est @ 1.57%

Est @ 1.69%

Est @ 1.78%

Present Value ($, Millions) Discounted @ 11%

US$185

US$189

US$148

US$143

US$130

US$118

US$108

US$98.7

US$90.4

US$82.8

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$1.3b

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 2.0%. 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$237m× (1 + 2.0%) ÷ (11%– 2.0%) = US$2.7b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$2.7b÷ ( 1 + 11%)10= US$928m

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$2.2b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$22.5, the company appears quite good value at a 44% 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.

dcf
dcf

Important 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 Rent-A-Center 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 1.634. 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 Rent-A-Center

Strength

  • Debt is well covered by cash flow.

  • Dividend is in the top 25% of dividend payers in the market.

Weakness

  • Earnings declined over the past year.

  • Interest payments on debt are not well covered.

Opportunity

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

  • Trading below our estimate of fair value by more than 20%.

Threat

  • Dividends are not covered by earnings.

  • Annual revenue is forecast to grow slower than the American market.

Next Steps:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. 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 Rent-A-Center, we've put together three relevant items you should explore:

  1. Risks: Take risks, for example - Rent-A-Center has 4 warning signs (and 1 which is a bit concerning) we think you should know about.

  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for RCII'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 NASDAQGS 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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