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. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.
See our latest analysis for Software
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. 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.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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
|Levered FCF (€, Millions)||€142.5m||€144.5m||€146.0m||€147.0m||€147.7m||€148.2m||€148.6m||€148.8m||€149.1m||€149.2m|
|Growth Rate Estimate Source||Analyst x5||Analyst x4||Analyst x1||It is @ 0.67%||Is @ 0.48%||Is @ 0.35%||Is @ 0.25%||Is @ 0.18%||Is @ 0.14%||Is @ 0.11%|
|Present Value (€, Millions) Discounted @ 6.8%||€133||€127||€120||€113||€106||€99.6||€93.5||€87.6||€82.1||€76.9|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = €1.0b
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 (0.03%) 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 6.8%.
Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = €149m× (1 + 0.03%) ÷ (6.8%– 0.03%) = €2.2b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= €2.2b÷ (1 + 6.8%)10= €1.1b
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 €2.2b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of €26.9, the company appears about fair value at an 8.3% discount to where the stock price currently trades. Remember though, that this is just an approximate valuation, and like any complex formula – garbage in, garbage out.
We would point out that 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 Software 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 6.8%, which is based on a leveraged beta of 1.134. 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 Software
- Debt is well covered by earnings.
- Earnings declined over the past year.
- Dividend is low compared to the top 25% of dividend payers in the Software market.
- Annual earnings are forecast to grow faster than the German market.
- Current share price is below our estimate of fair value.
- Debt is not well covered by operating cash flow.
- Dividends are not covered by earnings and cashflows.
- Revenue is forecast to grow slower than 20% per year.
Valuation is only one side of the coin in terms of building your investment thesis, and it 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. Rather it should be seen as a guide to “what assumptions need to be true for this stock to be under/overvalued?” For example, changes in the company’s cost of equity or the risk free rate can significantly impact the valuation. For Software, we’ve compiled three additional items you should further research:
- Risks: For example, we’ve discovered 2 warning signs for Software (1 doesn’t sit too well with us!) that you should be aware of before investing here.
- Future Earnings: How does SOW’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the coming 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 XTRA 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.