Is There An Opportunity With Splunk Inc.’s (NASDAQ:SPLK) 21% Undervaluation?

Does the May share price for Splunk Inc. (NASDAQ:SPLK) 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. This is done using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

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 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.

Check out our latest analysis for Splunk

What’s the estimated valuation?

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.

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

2020 2021 2022 2023 2024 2025 2026 2027 2028 2029
Levered FCF ($, Millions) -US$383.2m -US$351.3m US$228.7m US$938.4m US$1.22b US$1.53b US$1.75b US$1.95b US$2.11b US$2.24b
Growth Rate Estimate Source Analyst x22 Analyst x22 Analyst x19 Analyst x6 Analyst x3 Analyst x3 Est @ 14.88% Est @ 10.94% Est @ 8.18% Est @ 6.25%
Present Value ($, Millions) Discounted @ 7.3% -US$357.2 -US$305.3 US$185 US$709 US$859 US$1.0k US$1.1k US$1.1k US$1.1k US$1.1k

(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$6.5b

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 10-year government bond rate of 1.7%. We discount the terminal cash flows to today’s value at a cost of equity of 7.3%.

Terminal Value (TV)= FCF2029 × (1 + g) ÷ (r – g) = US$2.2b× (1 + 1.7%) ÷ 7.3%– 1.7%) = US$41b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$41b÷ ( 1 + 7.3%)10= US$20b

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$27b. 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$134, the company appears a touch undervalued at a 21% 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.

NasdaqGS:SPLK Intrinsic value May 4th 2020
NasdaqGS:SPLK Intrinsic value May 4th 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. 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 Splunk 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 7.3%, which is based on a levered beta of 1.017. 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:

Whilst important, DCF calculation 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. What is the reason for the share price to differ from the intrinsic value? For Splunk, We’ve compiled three pertinent factors you should further examine:

  1. Risks: As an example, we’ve found 4 warning signs for Splunk (1 doesn’t sit too well with us!) that you need to consider before investing here.
  2. Future Earnings: How does SPLK’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. Simply Wall St updates its DCF calculation for every US stock every day, so if you want to find the intrinsic value of any other stock just search here.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.