Are Investors Undervaluing Arco Platform Limited (NASDAQ:ARCE) By 28%?

Today we will run through one way of estimating the intrinsic value of Arco Platform Limited (NASDAQ:ARCE) by projecting its future cash flows and then discounting them to today's value. We will use the Discounted Cash Flow (DCF) model on this occasion. Don't get put off by the jargon, the math behind it is actually quite straightforward.

We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

View our latest analysis for Arco Platform

Step by step through the calculation

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. 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

	2022	2023	2024	2025	2026	2027	2028	2029	2030	2031
Levered FCF (R$, Millions)	R$78.5m	R$177.8m	R$266.1m	R$360.3m	R$451.6m	R$534.4m	R$605.9m	R$666.3m	R$716.5m	R$758.5m
Growth Rate Estimate Source	Analyst x2	Analyst x4	Est @ 49.73%	Est @ 35.38%	Est @ 25.34%	Est @ 18.32%	Est @ 13.4%	Est @ 9.95%	Est @ 7.54%	Est @ 5.86%
Present Value (R$, Millions) Discounted @ 8.4%	R$72.4	R$151	R$209	R$261	R$302	R$330	R$345	R$350	R$347	R$339

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = R$2.7b

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. 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 1.9%. We discount the terminal cash flows to today's value at a cost of equity of 8.4%.

Terminal Value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = R$758m× (1 + 1.9%) ÷ (8.4%– 1.9%) = R$12b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= R$12b÷ ( 1 + 8.4%)¹⁰= R$5.3b

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 R$8.1b. 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$22.0, the company appears a touch undervalued at a 28% 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.

Important assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Arco Platform 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 8.4%, which is based on a levered beta of 0.897. 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.

Looking Ahead:

Whilst important, the DCF calculation ideally won't be the sole piece of analysis you scrutinize for 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. What is the reason for the share price sitting below the intrinsic value? For Arco Platform, we've compiled three fundamental factors you should further research:

1. Financial Health: Does ARCE 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.
2. Future Earnings: How does ARCE'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 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 American stock every day, so if you want to find the intrinsic value of any other stock 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.