Stock Analysis

Roku, Inc. (NASDAQ:ROKU) Shares Could Be 42% Below Their Intrinsic Value Estimate

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NasdaqGS:ROKU
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How far off is Roku, Inc. (NASDAQ:ROKU) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by estimating the company's future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. 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. 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.

See our latest analysis for Roku

The Method

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 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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

2023 2024 2025 2026 2027 2028 2029 2030 2031 2032
Levered FCF ($, Millions) US$38.3m US$199.2m US$262.8m US$394.3m US$498.5m US$593.5m US$676.3m US$746.4m US$804.9m US$853.9m
Growth Rate Estimate Source Analyst x14 Analyst x10 Analyst x4 Analyst x3 Est @ 26.4% Est @ 19.08% Est @ 13.95% Est @ 10.36% Est @ 7.84% Est @ 6.08%
Present Value ($, Millions) Discounted @ 6.7% US$35.9 US$175 US$216 US$304 US$361 US$403 US$430 US$445 US$450 US$447

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$3.3b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 2.0%. We discount the terminal cash flows to today's value at a cost of equity of 6.7%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$854m× (1 + 2.0%) ÷ (6.7%– 2.0%) = US$19b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$19b÷ ( 1 + 6.7%)10= US$9.7b

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$13b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of US$54.6, the company appears quite undervalued at a 42% 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
NasdaqGS:ROKU Discounted Cash Flow October 29th 2022

Important Assumptions

We would point out that 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 Roku 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 6.7%, which is based on a levered beta of 1.004. 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 Roku

Strength
  • Debt is not viewed as a risk.
Weakness
  • Shareholders have been diluted in the past year.
Opportunity
  • Has sufficient cash runway for more than 3 years based on current free cash flows.
  • Trading below our estimate of fair value by more than 20%.
Threat
  • Not expected to become profitable over the next 3 years.

Moving On:

Whilst important, the DCF calculation 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?" 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. Why is the intrinsic value higher than the current share price? For Roku, there are three further factors you should assess:

  1. Risks: Be aware that Roku is showing 1 warning sign in our investment analysis , you should know about...
  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for ROKU's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.
  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. 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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