Today I will be providing a simple run through of a valuation method used to estimate the attractiveness of Rocky Mountain Dealerships Inc (TSE:RME) as an investment opportunity by projecting its future cash flows and then discounting them to today’s value. I will be using the discounted cash flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. If you are reading this and its not September 2018 then I highly recommend you check out the latest calculation for Rocky Mountain Dealerships by following the link below.
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. To start off with we need to estimate the next five years of cash flows. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount this to its value today and sum up the total to get the present value of these cash flows.
5-year cash flow forecast
|Levered FCF (CA$, Millions)||CA$28.00||CA$27.81||CA$27.62||CA$27.43||CA$27.25|
|Source||Analyst x1||Est @ -0.68%||Est @ -0.68%||Est @ -0.68%||Est @ -0.68%|
|Present Value Discounted @ 17.66%||CA$23.80||CA$20.09||CA$16.96||CA$14.31||CA$12.08|
Present Value of 5-year Cash Flow (PVCF)= CA$87.2m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after the five years. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 2.3%. We discount this to today’s value at a cost of equity of 17.7%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = CA$27.2m × (1 + 2.3%) ÷ (17.7% – 2.3%) = CA$182.0m
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = CA$182.0m ÷ ( 1 + 17.7%)5 = CA$80.7m
The total value is the sum of cash flows for the next five years and the discounted terminal value, which results in the Total Equity Value, which in this case is CA$168.0m. The last step is to then divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) then we use the equivalent number. This results in an intrinsic value of CA$8.45. Relative to the current share price of CA$10.43, the stock is fair value, maybe slightly overvalued at the time of writing.
I’d like to point out that 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 my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Rocky Mountain Dealerships as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 17.7%, which is based on a levered beta of 2. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For RME, there are three important aspects you should further examine:
- Financial Health: Does RME 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 RME’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 RME? 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 does a DCF calculation for every CA stock every 6 hours, so if you want to find the intrinsic value of any other stock 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.