Stock Analysis

A Look At The Fair Value Of Paycom Software, Inc. (NYSE:PAYC)

NYSE:PAYC
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Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, Paycom Software fair value estimate is US$314
  • Current share price of US$285 suggests Paycom Software is potentially trading close to its fair value
  • The US$370 analyst price target for PAYC is 18% more than our estimate of fair value

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Paycom Software, Inc. (NYSE:PAYC) as an investment opportunity by taking the forecast future cash flows of the company and discounting them back to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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 Paycom Software

Is Paycom Software Fairly Valued?

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. 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.

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) estimate

2023 2024 2025 2026 2027 2028 2029 2030 2031 2032
Levered FCF ($, Millions) US$306.6m US$417.5m US$567.1m US$741.3m US$890.9m US$1.00b US$1.10b US$1.17b US$1.24b US$1.30b
Growth Rate Estimate Source Analyst x13 Analyst x12 Analyst x4 Analyst x2 Analyst x2 Est @ 12.45% Est @ 9.35% Est @ 7.17% Est @ 5.66% Est @ 4.59%
Present Value ($, Millions) Discounted @ 7.3% US$286 US$363 US$459 US$559 US$626 US$656 US$668 US$667 US$657 US$640

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$5.6b

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 5-year average of the 10-year government bond yield of 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 7.3%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$1.3b× (1 + 2.1%) ÷ (7.3%– 2.1%) = US$25b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$25b÷ ( 1 + 7.3%)10= US$13b

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 US$18b. 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$285, the company appears about fair value at a 9.0% 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
NYSE:PAYC Discounted Cash Flow May 20th 2023

The Assumptions

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 Paycom Software 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 0.876. 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.

SWOT Analysis for Paycom Software

Strength
  • Earnings growth over the past year exceeded the industry.
  • Debt is not viewed as a risk.
Weakness
  • Dividend is low compared to the top 25% of dividend payers in the Professional Services market.
Opportunity
  • Annual earnings are forecast to grow faster than the American market.
  • Current share price is below our estimate of fair value.
Threat
  • Revenue is forecast to grow slower than 20% per year.

Next Steps:

Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. DCF models are not the be-all and end-all of investment valuation. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Paycom Software, there are three additional elements you should consider:

  1. Risks: To that end, you should be aware of the 1 warning sign we've spotted with Paycom Software .
  2. Future Earnings: How does PAYC'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 NYSE 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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.