Calculating The Intrinsic Value Of Rio Tinto Group (LON:RIO)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, Rio Tinto Group fair value estimate is UK£49.58

• Rio Tinto Group's UK£53.11 share price indicates it is trading at similar levels as its fair value estimate

• Our fair value estimate is 19% lower than Rio Tinto Group's analyst price target of US$60.84

Today we will run through one way of estimating the intrinsic value of Rio Tinto Group (LON:RIO) by taking the expected future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. There's really not all that much to it, even though it might appear quite complex.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

See our latest analysis for Rio Tinto Group

Is Rio Tinto Group Fairly Valued?

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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	US$7.31b	US$7.66b	US$9.02b	US$10.9b	US$9.14b	US$8.18b	US$7.63b	US$7.30b	US$7.13b	US$7.04b
Growth Rate Estimate Source	Analyst x9	Analyst x8	Analyst x5	Analyst x2	Analyst x1	Est @ -10.48%	Est @ -6.80%	Est @ -4.23%	Est @ -2.43%	Est @ -1.17%
Present Value ($, Millions) Discounted @ 8.4%	US$6.7k	US$6.5k	US$7.1k	US$7.9k	US$6.1k	US$5.1k	US$4.3k	US$3.8k	US$3.5k	US$3.2k

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$54b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (1.8%) 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 8.4%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$7.0b× (1 + 1.8%) ÷ (8.4%– 1.8%) = US$109b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$109b÷ ( 1 + 8.4%)¹⁰= US$49b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$103b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of UK£53.1, the company appears around fair value at the time of writing. 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. 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 Rio Tinto 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 8.4%, which is based on a levered beta of 1.203. 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 Rio Tinto Group

Strength

• Debt is not viewed as a risk.

• Dividends are covered by earnings and cash flows.

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

Weakness

• Earnings declined over the past year.

Opportunity

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

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

Threat

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

Next Steps:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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 Rio Tinto Group, there are three additional aspects you should further examine:

1. Risks: For example, we've discovered 2 warning signs for Rio Tinto Group that you should be aware of before investing here.

2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for RIO'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. Simply Wall St updates its DCF calculation for every British stock every day, so if you want to find the intrinsic value of any other stock 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.