Key Insights

The projected fair value for Redde Northgate is UK£3.90 based on Dividend Discount Model With UK£3.30 share price, Redde Northgate appears to be trading close to its estimated fair value The UK£4.59 analyst price target for REDD is 17% more than our estimate of fair value

Today we will run through one way of estimating the intrinsic value of Redde Northgate plc (LON:REDD) by taking the expected future cash flows and discounting them to today's 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!

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. 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 Redde Northgate

Is Redde Northgate Fairly Valued?

We have to calculate the value of Redde Northgate slightly differently to other stocks because it is a transportation company. Instead of using free cash flows, which are hard to estimate and often not reported by analysts in this industry, dividends per share (DPS) payments are used. Unless a company pays out the majority of its FCF as a dividend, this method will typically underestimate the value of the stock. The 'Gordon Growth Model' is used, which simply assumes that dividend payments will continue to increase at a sustainable growth rate forever. The dividend is expected to grow at an annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.4%. We then discount this figure to today's value at a cost of equity of 7.8%. Relative to the current share price of UK£3.3, the company appears about fair value at a 16% 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.



Value Per Share = Expected Dividend Per Share / (Discount Rate - Perpetual Growth Rate)

= UK£0.3 / (7.8% – 1.4%)

= UK£3.9 dcf

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 Redde Northgate 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 7.8%, which is based on a levered beta of 1.086. 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 Redde Northgate

Strength

Earnings growth over the past year exceeded the industry.

Debt is well covered by earnings.

Dividends are covered by earnings and cash flows.

Dividend is in the top 25% of dividend payers in the market.

Weakness

No major weaknesses identified for REDD.

Opportunity

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

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

Threat

Debt is not well covered by operating cash flow.

Annual earnings are forecast to decline for the next 3 years.

Looking Ahead:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching 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. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Redde Northgate, there are three essential aspects you should look at:

Risks: For example, we've discovered 3 warning signs for Redde Northgate (2 are a bit unpleasant!) that you should be aware of before investing here. Future Earnings: How does REDD'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. 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.