Estimating The Intrinsic Value Of Zynga Inc. (NASDAQ:ZNGA)

Today we’ll do a simple run through of a valuation method used to estimate the attractiveness of Zynga Inc. (NASDAQ:ZNGA) as an investment opportunity by estimating the company’s future cash flows and discounting them to their present value. Our analysis will employ the Discounted Cash Flow (DCF) model. Before you think you won’t be able to understand it, just read on! It’s actually much less complex than you’d imagine.

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. 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 Zynga

The 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 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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
Levered FCF ($, Millions) US$519.1m US$566.2m US$601.6m US$631.9m US$658.5m US$682.2m US$703.9m US$724.4m US$743.9m US$762.9m
Growth Rate Estimate Source Analyst x7 Analyst x4 Est @ 6.26% Est @ 5.05% Est @ 4.2% Est @ 3.6% Est @ 3.19% Est @ 2.9% Est @ 2.69% Est @ 2.55%
Present Value ($, Millions) Discounted @ 8.3% US$479 US$483 US$474 US$460 US$443 US$424 US$404 US$384 US$364 US$345

(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$4.3b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.2%. We discount the terminal cash flows to today’s value at a cost of equity of 8.3%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$763m× (1 + 2.2%) ÷ (8.3%– 2.2%) = US$13b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$13b÷ ( 1 + 8.3%)10= US$5.8b

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$10b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$8.3, the company appears about fair value at a 12% 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.

dcf
NasdaqGS:ZNGA Discounted Cash Flow September 17th 2020

Important assumptions

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 Zynga 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 8.3%, which is based on a levered beta of 1.005. 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.

Next Steps:

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. 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 Zynga, we’ve compiled three important elements you should assess:

  1. Risks: Take risks, for example – Zynga has 2 warning signs we think you should be aware of.
  2. Future Earnings: How does ZNGA’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 NASDAQGS 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.
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