Stock Analysis

A Look At The Intrinsic Value Of Appen Limited (ASX:APX)

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ASX:APX
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Does the June share price for Appen Limited (ASX:APX) 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 their present value. Our analysis will employ 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 still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.

See our latest analysis for Appen

The model

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. In the first stage we need to estimate the cash flows to the business over the next ten years. 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, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) forecast

2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
Levered FCF (A$, Millions) AU$45.8m AU$78.3m AU$92.7m AU$100.8m AU$107.6m AU$113.3m AU$118.2m AU$122.4m AU$126.2m AU$129.6m
Growth Rate Estimate Source Analyst x2 Analyst x2 Analyst x2 Est @ 8.82% Est @ 6.75% Est @ 5.3% Est @ 4.29% Est @ 3.58% Est @ 3.08% Est @ 2.73%
Present Value (A$, Millions) Discounted @ 7.0% AU$42.8 AU$68.3 AU$75.6 AU$76.9 AU$76.7 AU$75.5 AU$73.6 AU$71.2 AU$68.6 AU$65.8

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = AU$694m

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 (1.9%) 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 7.0%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = AU$130m× (1 + 1.9%) ÷ (7.0%– 1.9%) = AU$2.6b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= AU$2.6b÷ ( 1 + 7.0%)10= AU$1.3b

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 AU$2.0b. In the final step we divide the equity value by the number of shares outstanding. Compared to the current share price of AU$13.9, the company appears about fair value at a 15% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf
ASX:APX Discounted Cash Flow June 12th 2021

The assumptions

Now 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 Appen 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 7.0%, which is based on a levered beta of 1.079. 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.

Moving On:

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. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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 Appen, there are three important aspects you should look at:

  1. Risks: To that end, you should be aware of the 2 warning signs we've spotted with Appen .
  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for APX's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
  3. 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. Simply Wall St updates its DCF calculation for every Australian stock every day, so if you want to find the intrinsic value of any other stock just search here.

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