An Intrinsic Calculation For Reckitt Benckiser Group plc (LON:RKT) Suggests It's 43% Undervalued

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Reckitt Benckiser Group fair value estimate is UK£79.74

• Reckitt Benckiser Group's UK£45.12 share price signals that it might be 43% undervalued

• Analyst price target for RKT is UK£57.45 which is 28% below our fair value estimate

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Reckitt Benckiser Group plc (LON:RKT) as an investment opportunity by estimating the company's future cash flows and discounting them to their present 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. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

View our latest analysis for Reckitt Benckiser Group

Crunching The Numbers

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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF (£, Millions)	UK£2.37b	UK£2.66b	UK£2.77b	UK£2.84b	UK£2.78b	UK£2.76b	UK£2.76b	UK£2.77b	UK£2.80b	UK£2.83b
Growth Rate Estimate Source	Analyst x6	Analyst x6	Analyst x4	Analyst x2	Analyst x1	Est @ -0.78%	Est @ -0.05%	Est @ 0.46%	Est @ 0.81%	Est @ 1.06%
Present Value (£, Millions) Discounted @ 6.0%	UK£2.2k	UK£2.4k	UK£2.3k	UK£2.2k	UK£2.1k	UK£1.9k	UK£1.8k	UK£1.7k	UK£1.7k	UK£1.6k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£20b

The second stage is also known as Terminal Value, this is the business's cash flow after 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 (1.6%) 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 6.0%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = UK£2.8b× (1 + 1.6%) ÷ (6.0%– 1.6%) = UK£66b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= UK£66b÷ ( 1 + 6.0%)¹⁰= UK£36b

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£56b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of UK£45.1, the company appears quite undervalued at a 43% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

dcf

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the 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 Reckitt Benckiser Group 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 6.0%, which is based on a levered beta of 0.800. 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 Reckitt Benckiser Group

Strength

• Debt is well covered by earnings and cashflows.

• Dividends are covered by earnings and cash flows.

Weakness

• Earnings declined over the past year.

• Dividend is low compared to the top 25% of dividend payers in the Household Products 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

• Annual revenue is forecast to grow slower than the British market.

Looking Ahead:

Whilst important, the DCF calculation is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. 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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For Reckitt Benckiser Group, we've put together three fundamental items you should consider:

1. Risks: Case in point, we've spotted 3 warning signs for Reckitt Benckiser Group you should be aware of.

2. Future Earnings: How does RKT'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 LSE 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.