Today we’ll do a simple run through of a valuation method used to estimate the attractiveness of Proofpoint, Inc. (NASDAQ:PFPT) as an investment opportunity by taking the expected future cash flows and discounting them to their present value. I will be using the Discounted Cash Flow (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward.
Remember though, that there are many ways to estimate a company’s value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
We’re using the 2-stage growth model, which simply means we take in account two stages of company’s growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. To start off with, we need to estimate 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, and so the sum of these future cash flows is then discounted to today’s value:
10-year free cash flow (FCF) estimate
|Levered FCF ($, Millions)||US$116.8m||US$254.9m||US$303.2m||US$409.1m||US$489.5m||US$549.0m||US$599.5m||US$642.0m||US$678.1m||US$709.4m|
|Growth Rate Estimate Source||Analyst x17||Analyst x19||Analyst x4||Analyst x2||Analyst x2||Est @ 12.17%||Est @ 9.18%||Est @ 7.09%||Est @ 5.63%||Est @ 4.61%|
|Present Value ($, Millions) Discounted @ 8.4%||US$108||US$217||US$238||US$296||US$327||US$338||US$340||US$336||US$327||US$316|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$2.8b
The second stage is also known as Terminal Value, this is the business’s cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 10-year government bond rate of 2.2%. We discount the terminal cash flows to today’s value at a cost of equity of 8.4%.
Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = US$709m× (1 + 2.2%) ÷ 8.4%– 2.2%) = US$12b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$12b÷ ( 1 + 8.4%)10= US$5.2b
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$8.0b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of US$119, the company appears about fair value at a 16% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula – garbage in, garbage out.
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 Proofpoint 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 1.033. 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.
Although the valuation of a company is important, it shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to “what assumptions need to be true for this stock to be under/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 Proofpoint, We’ve compiled three additional aspects you should look at:
- Risks: You should be aware of the 2 warning signs for Proofpoint we’ve uncovered before considering an investment in the company.
- Future Earnings: How does PFPT’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 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.
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This article by Simply Wall St is general in nature. 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. Thank you for reading.