How far off is Constellation Software Inc. (TSE:CSU) from its intrinsic value? Using the most recent financial data, I am going to take a look at whether the stock is fairly priced by projecting its future cash flows and then discounting them to today’s value. I will use the discounted cash flows (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model. Please also note that this article was written in December 2018 so be sure check out the updated calculation by following the link below.
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. In the first stage we need to estimate the cash flows to the business over the next five years. For this I used the consensus of the analysts covering the stock, as you can see below. I then discount this to its value today and sum up the total to get the present value of these cash flows.
5-year cash flow estimate
|Levered FCF ($, Millions)||$692.86||$884.60||$1.03k||$1.19k||$1.39k|
|Source||Analyst x4||Analyst x2||Est @ 16.21%||Est @ 16.21%||Est @ 16%, capped from 16.21%|
|Present Value Discounted @ 8.47%||$638.76||$751.87||$805.57||$863.11||$923.04|
Present Value of 5-year Cash Flow (PVCF)= US$4.0b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after the five years. The Gordon Growth formula is used to calculate Terminal Value at an annual growth rate equal to the 10-year government bond rate of 2.3%. We discount this to today’s value at a cost of equity of 8.5%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = US$1.4b × (1 + 2.3%) ÷ (8.5% – 2.3%) = US$23b
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = US$23b ÷ ( 1 + 8.5%)5 = US$15b
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is US$19b. To get the intrinsic value per share, we divide this by the total number of shares outstanding, or the equivalent number if this is a depositary receipt or ADR. This results in an intrinsic value of CA$1240.77. Compared to the current share price of CA$836.44, the stock is quite good value at a 33% discount to what it is available for right now.
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 my result, have a go at the calculation yourself and play with the assumptions. Because we are looking at Constellation Software as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 8.5%, which is based on a levered beta of 0.800. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For CSU, I’ve put together three fundamental aspects you should further research:
- Financial Health: Does CSU have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors like leverage and risk.
- Future Earnings: How does CSU’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 High Quality Alternatives: Are there other high quality stocks you could be holding instead of CSU? 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 does a DCF calculation for every CA stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.
To help readers see past the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price-sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned. For errors that warrant correction please contact the editor at email@example.com.