Rentokil Initial plc (LON:RTO) Shares Could Be 30% Below Their Intrinsic Value Estimate

Key Insights

• Rentokil Initial's estimated fair value is UK£5.80 based on 2 Stage Free Cash Flow to Equity

• Rentokil Initial is estimated to be 30% undervalued based on current share price of UK£4.04

• Analyst price target for RTO is UK£5.52 which is 5.0% below our fair value estimate

Does the January share price for Rentokil Initial plc (LON:RTO) reflect what it's really worth? Today, we will estimate the stock's intrinsic value 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. It may sound complicated, but actually it is quite simple!

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 Rentokil Initial

Crunching The Numbers

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (£, Millions)	UK£561.6m	UK£673.4m	UK£786.0m	UK£1.02b	UK£1.04b	UK£1.06b	UK£1.08b	UK£1.10b	UK£1.12b	UK£1.14b
Growth Rate Estimate Source	Analyst x8	Analyst x8	Analyst x3	Analyst x1	Analyst x1	Est @ 2.02%	Est @ 1.87%	Est @ 1.76%	Est @ 1.69%	Est @ 1.64%
Present Value (£, Millions) Discounted @ 8.0%	UK£520	UK£578	UK£625	UK£749	UK£711	UK£671	UK£634	UK£597	UK£562	UK£530

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£6.2b

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 1.5%. We discount the terminal cash flows to today's value at a cost of equity of 8.0%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£1.1b× (1 + 1.5%) ÷ (8.0%– 1.5%) = UK£18b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£18b÷ ( 1 + 8.0%)¹⁰= UK£8.3b

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 UK£15b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of UK£4.0, the company appears quite good value at a 30% 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

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. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 Rentokil Initial 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 8.0%, which is based on a levered beta of 1.090. 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 Rentokil Initial

Strength

• Debt is well covered by earnings.

• Dividends are covered by earnings and cash flows.

Weakness

• Earnings growth over the past year underperformed the Commercial Services industry.

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

Opportunity

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

• Good value based on P/E ratio and estimated fair value.

Threat

• Debt is not well covered by operating cash flow.

• Revenue is forecast to grow slower than 20% per year.

Moving On:

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. It's not possible to obtain a foolproof valuation with a DCF model. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. Can we work out why the company is trading at a discount to intrinsic value? For Rentokil Initial, we've compiled three fundamental items you should assess:

1. Risks: You should be aware of the 3 warning signs for Rentokil Initial (1 is concerning!) we've uncovered before considering an investment in the company.

2. Future Earnings: How does RTO'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. Simply Wall St updates its DCF calculation for every British stock every day, so if you want to find the intrinsic value of any other stock just search here.

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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.