Key Insights

• RGC Resources' estimated fair value is US$23.96 based on Dividend Discount Model
• With US$20.14 share price, RGC Resources appears to be trading close to its estimated fair value
• The average premium for RGC Resources' competitorsis currently 41%

Does the February share price for RGC Resources, Inc. (NASDAQ:RGCO) 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. 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.

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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for RGC Resources

Crunching The Numbers

As RGC Resources operates in the gas utilities sector, we need to calculate the intrinsic value slightly differently. In this approach dividends per share (DPS) are used, as free cash flow is difficult to estimate and often not reported by analysts. Unless a company pays out the majority of its FCF as a dividend, this method will typically underestimate the value of the stock. We use the Gordon Growth Model, which assumes dividend will grow into perpetuity at a rate that can be sustained. For a number of reasons a very conservative growth rate is used that cannot exceed that of a company's Gross Domestic Product (GDP). In this case we used the 5-year average of the 10-year government bond yield (2.8%). The expected dividend per share is then discounted to today's value at a cost of equity of 6.2%. Compared to the current share price of US$20.1, the company appears about fair value at a 16% 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.

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

= US$0.8 / (6.2% – 2.8%)

= US$24.0

Important 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 RGC Resources 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 6.2%, 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 RGC Resources

Next Steps:

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. It's not possible to obtain a foolproof valuation with a DCF model. 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. 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. For RGC Resources, we've put together three important elements you should further research:

1. Risks: We feel that you should assess the 3 warning signs for RGC Resources (2 are a bit unpleasant!) we've flagged before making an investment in the company.
2. Future Earnings: How does RGCO'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 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 NASDAQGM 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.