Today, we’re going to take a simple look at a valuation method used to estimate the attractiveness of Republic Services, Inc. (NYSE: RSG) as an investment opportunity by taking expected future cash flows and discounting them to their present value. We will use the Discounted Cash Flow (DCF) model for this purpose. Before you think you can’t figure it out, just read on! It’s actually a lot less complex than you might imagine.
Businesses can be valued in many ways, which is why we emphasize that a DCF is not perfect for all situations. For those who are passionate about equity analysis, the Simply Wall St analysis template here may be something that interests you.
What is the estimated value?
We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “sustained growth”. In the first step, we need to estimate the company’s cash flow over the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.
Generally, we assume that a dollar today is worth more than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at an estimate of present value:
Estimated free cash flow (FCF) over 10 years
|Leveraged FCF ($, millions)||$1.87 billion||US$2.09 billion||US$2.12 billion||$2.20 billion||US$2.26 billion||$2.32 billion||$2.38 billion||US$2.43 billion||$2.49 billion||$2.54 billion|
|Growth rate estimate Source||Analyst x11||Analyst x7||Analyst x2||Analyst x2||Is at 2.92%||Is at 2.64%||Is at 2.44%||East @ 2.3%||Is at 2.21%||Is at 2.14%|
|Present value (in millions of dollars) discounted at 6.7%||$1.7,000||$1.8,000||$1.7,000||$1.7,000||$1,600||$1,600||$1.5k||$1,400||$1,400||$1,300|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $16 billion
After calculating the present value of future cash flows over the initial 10-year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first stage. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 2.0%. We discount the terminal cash flows to their present value at a cost of equity of 6.7%.
Terminal value (TV)= FCF2032 × (1 + g) ÷ (r – g) = $2.5 billion × (1 + 2.0%) ÷ (6.7%–2.0%) = $55 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= $55 billion ÷ (1 + 6.7%)ten= $29 billion
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is $45 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Based on the current share price of US$135, the company appears to be about fair value at a 5.0% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.
We emphasize that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. If you disagree with these results, try the math yourself and play around with the assumptions. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Republic Services 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 factors in debt. In this calculation, we used 6.7%, which is based on a leveraged beta of 1.005. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
While important, the DCF calculation will ideally not be the only piece of analysis you look at for a business. The DCF model is not a perfect stock valuation tool. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under/overvalued?” For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on the valuation. For Republic Services, we’ve compiled three relevant things you should consider:
- Risks: For example, we have identified 2 warning signs for the services of the Republic of which you should be aware.
- Management:Did insiders increase their shares to take advantage of market sentiment about RSG’s future prospects? Discover our management and board analysis with information on CEO compensation and governance factors.
- Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of what else you might be missing!
PS. The Simply Wall St app performs a discounted cash flow valuation for every stock on the NYSE every day. If you want to find the calculation for other stocks just search here.
Valuation is complex, but we help make it simple.
Find out if Republic Services is potentially overvalued or undervalued by viewing our full analysis, which includes fair value estimates, risks and warnings, dividends, insider trading and financial health.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.