Key Insights

Using the 2 Stage Free Cash Flow to Equity, Renishaw fair value estimate is UK£24.14 Current share price of UK£32.50 suggests Renishaw is potentially 35% overvalued Analyst price target for RSW is UK£38.60, which is 60% above our fair value estimate

In this article we are going to estimate the intrinsic value of Renishaw plc (LON:RSW) by taking the expected future cash flows and discounting them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. 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 Renishaw

The Calculation

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 begin with, we have to get estimates of 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) forecast

2025 2026 2027 2028 2029 2030 2031 2032 2033 2034 Levered FCF (£, Millions)  UK£80.3m UK£84.6m UK£90.3m UK£94.7m UK£98.5m UK£101.9m UK£105.0m UK£107.9m UK£110.7m UK£113.4m Growth Rate Estimate Source Analyst x3 Analyst x3 Analyst x3 Est @ 4.86% Est @ 4.03% Est @ 3.46% Est @ 3.05% Est @ 2.77% Est @ 2.57% Est @ 2.43% Present Value (£, Millions) Discounted @ 7.3%  UK£74.8 UK£73.4 UK£73.0 UK£71.3 UK£69.1 UK£66.6 UK£63.9 UK£61.2 UK£58.5 UK£55.8

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = UK£668m

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 7.3%.

Story Continues

Terminal Value (TV)= FCF2034 × (1 + g) ÷ (r – g) = UK£113m× (1 + 2.1%) ÷ (7.3%– 2.1%) = UK£2.2b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= UK£2.2b÷ ( 1 + 7.3%)10= UK£1.1b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is UK£1.8b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of UK£32.5, the company appears potentially overvalued at the time of writing. 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.LSE:RSW Discounted Cash Flow January 15th 2025

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 Renishaw 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 7.3%, which is based on a levered beta of 1.080. 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 Renishaw

Strength

Debt is not viewed as a risk.

Weakness

Earnings declined over the past year.

Dividend is low compared to the top 25% of dividend payers in the Electronic market.

Opportunity

Annual revenue is forecast to grow faster than the British market.

Good value based on P/E ratio compared to estimated Fair P/E ratio.

Threat

Dividends are not covered by cash flow.

Annual earnings are forecast to grow slower than the British market.

Moving On:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. Why is the intrinsic value lower than the current share price? For Renishaw, there are three relevant factors you should consider:

Risks: Be aware that  Renishaw is showing  2 warning signs in our investment analysis, you should know about... Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for RSW's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors. 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 LSE 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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