Estimating The Intrinsic Value Of Lynas Rare Earths Limited (ASX:LYC)

Key Insights

• Lynas Rare Earths' estimated fair value is AU$7.42 based on 2 Stage Free Cash Flow to Equity

• Current share price of AU$6.73 suggests Lynas Rare Earths is potentially trading close to its fair value

• The AU$7.27 analyst price target for LYC is 2.0% less than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of Lynas Rare Earths Limited (ASX:LYC) by taking the expected future cash flows and discounting them to their present value. Our analysis will employ the Discounted Cash Flow (DCF) model. Believe it or not, it's not too difficult to follow, as you'll see from our example!

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

View our latest analysis for Lynas Rare Earths

Is Lynas Rare Earths Fairly Valued?

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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 (A$, Millions)	-AU$549.8m	AU$17.4m	AU$519.6m	AU$466.0m	AU$475.0m	AU$484.1m	AU$493.8m	AU$504.1m	AU$514.9m	AU$526.1m
Growth Rate Estimate Source	Analyst x4	Analyst x2	Analyst x3	Analyst x1	Analyst x1	Est @ 1.91%	Est @ 2.01%	Est @ 2.09%	Est @ 2.14%	Est @ 2.18%
Present Value (A$, Millions) Discounted @ 7.5%	-AU$511	AU$15.0	AU$418	AU$348	AU$330	AU$313	AU$297	AU$282	AU$268	AU$254

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$2.0b

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. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (2.3%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 7.5%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = AU$526m× (1 + 2.3%) ÷ (7.5%– 2.3%) = AU$10b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= AU$10b÷ ( 1 + 7.5%)¹⁰= AU$4.9b

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 AU$6.9b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of AU$6.7, the company appears about fair value at a 9.3% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

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. 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 Lynas Rare Earths 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 7.5%, which is based on a levered beta of 1.148. 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 Lynas Rare Earths

Strength

• Debt is not viewed as a risk.

Weakness

• Earnings declined over the past year.

Opportunity

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

• Current share price is below our estimate of fair value.

Threat

• No apparent threats visible for LYC.

Next Steps:

Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Lynas Rare Earths, we've put together three pertinent elements you should assess:

1. Risks: We feel that you should assess the 2 warning signs for Lynas Rare Earths (1 shouldn't be ignored!) we've flagged before making an investment in the company.

2. Future Earnings: How does LYC'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the ASX every day. If you want to find the calculation for other stocks 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.