A Look At The Intrinsic Value Of 2U, Inc. (NASDAQ:TWOU)

Key Insights

• Using the 2 Stage Free Cash Flow to Equity, 2U fair value estimate is US$0.80
• 2U's US$0.78 share price indicates it is trading at similar levels as its fair value estimate
• Analyst price target for TWOU is US$3.32, which is 317% above our fair value estimate

Today we'll do a simple run through of a valuation method used to estimate the attractiveness of 2U, Inc. (NASDAQ:TWOU) as an investment opportunity by projecting its future cash flows and then discounting them to today's value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Don't get put off by the jargon, the math behind it is actually quite straightforward.

We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. 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.

View our latest analysis for 2U

The Model

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.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) forecast

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	US$39.0m	US$15.0m	US$6.51m	US$3.97m	US$2.92m	US$2.39m	US$2.11m	US$1.95m	US$1.85m	US$1.81m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Est @ -56.61%	Est @ -38.96%	Est @ -26.61%	Est @ -17.96%	Est @ -11.91%	Est @ -7.67%	Est @ -4.70%	Est @ -2.63%
Present Value ($, Millions) Discounted @ 12%	US$34.8	US$11.9	US$4.6	US$2.5	US$1.6	US$1.2	US$0.9	US$0.8	US$0.7	US$0.6

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$60m

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 2.2%. We discount the terminal cash flows to today's value at a cost of equity of 12%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$1.8m× (1 + 2.2%) ÷ (12%– 2.2%) = US$18m

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$18m÷ ( 1 + 12%)¹⁰= US$5.8m

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$65m. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$0.8, the company appears about fair value at a 2.1% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

The Assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 2U 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 12%, which is based on a levered beta of 2.000. 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 2U

Next Steps:

Although the valuation of a company is important, it 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?" For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. For 2U, there are three essential aspects you should explore:

1. Risks: Every company has them, and we've spotted 5 warning signs for 2U (of which 1 doesn't sit too well with us!) you should know about.
2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for TWOU'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NASDAQGS every day. If you want to find the calculation for other stocks just search here.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.