An Intrinsic Calculation For Raytheon Technologies Corporation (NYSE:RTX) Suggests It's 23% Undervalued

Key Insights

• The projected fair value for Raytheon Technologies is US$121 based on 2 Stage Free Cash Flow to Equity

• Raytheon Technologies' US$93.12 share price signals that it might be 23% undervalued

• Our fair value estimate is 9.6% higher than Raytheon Technologies' analyst price target of US$110

Does the May share price for Raytheon Technologies Corporation (NYSE:RTX) 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. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Believe it or not, it's not too difficult to follow, as you'll see from our example!

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. 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 Raytheon Technologies

Is Raytheon Technologies 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. To start off with, we need to estimate 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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	US$4.88b	US$6.67b	US$8.40b	US$9.72b	US$10.2b	US$10.6b	US$11.0b	US$11.3b	US$11.6b	US$11.9b
Growth Rate Estimate Source	Analyst x11	Analyst x10	Analyst x8	Analyst x2	Analyst x1	Est @ 3.81%	Est @ 3.30%	Est @ 2.94%	Est @ 2.69%	Est @ 2.52%
Present Value ($, Millions) Discounted @ 7.4%	US$4.5k	US$5.8k	US$6.8k	US$7.3k	US$7.2k	US$6.9k	US$6.7k	US$6.4k	US$6.1k	US$5.8k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$63b

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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 7.4%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$12b× (1 + 2.1%) ÷ (7.4%– 2.1%) = US$230b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$230b÷ ( 1 + 7.4%)¹⁰= US$113b

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 US$176b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of US$93.1, the company appears a touch undervalued at a 23% 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

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 Raytheon Technologies 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 7.4%, which is based on a levered beta of 0.888. 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 Raytheon Technologies

Strength

• Earnings growth over the past year exceeded the industry.

• Debt is well covered by earnings.

Weakness

• Dividend is low compared to the top 25% of dividend payers in the Aerospace & Defense market.

Opportunity

• Annual earnings are forecast to grow for the next 3 years.

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

Threat

• Debt is not well covered by operating cash flow.

• Dividends are not covered by cash flow.

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

Looking Ahead:

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. The DCF model is not a perfect stock valuation tool. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. 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 Raytheon Technologies, we've put together three fundamental elements you should look at:

1. Risks: We feel that you should assess the 2 warning signs for Raytheon Technologies we've flagged before making an investment in the company.

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