Knowing which valuation model to use for financial analysis can be incredibly confusing for even the most seasoned of investors. For instance, while my relative valuation model tells me Check Point Software Technologies Ltd’s (NASDAQ:CHKP) is overvalued by 98.18%, my discounted cash flow (DCF) model signals a 33.77% undervaluation instead. Which model do I listen to and more importantly why?
Examining intrinsic valuation
At the heart of the DCF is the basic assumption that a firm’s intrinsic valuation is equivalent to the sum of all its future free cash flows (FCF). As those familiar with the DCF will know, forecasting FCFs reliably past 5 years is often a difficult and subjective task, which is why I’ve used analyst FCF forecasts as a starting point for my model. When I discount all of CHKP’s future FCFs by 11%, I obtain an equity value of $US$12.5b, then 156.21k shares outstanding are divided through. This results in an intrinsic value of $79.87. Take a look at how I arrived at this intrinsic value here.,
Before we move on, let’s evaluate whether this number is accurate. Since it is generally impossible to forecast FCFs indefinitely, it is common for analysts to forecast for an explicit forecast horizon and then assume the company is mature by the end of that period and in a stable growth phase. At -3.6%, final year FCF growth is unsustainably low. If this assumption held true, CHKP would shrink to a point where it would cease to exist very soon, which is a highly unlikely outcome. Since these assumptions are far too extreme and unrealistic, one way of improving our DCF is to extend our forecast horizon by another few years until FCF growth moderates to a more sustainable rate. However, the trade-off is that there are less analyst forecasts the further in the future we go.
Examining relative valuation
While DCF models sum up future FCFs, relative valuation models are based on the idea that investors should pay the same price for two companies with identical risk and return profiles. Since the biggest dilemma is finding companies that are similar to CHKP, a viable proxy would be the overall Software industry itself. The calculations for relative valuation are quite simple. By multiplying CHKP’s earnings by the industry’s P/E ratio, we can obtain CHKP’s fair value of $211.73, which tells us that it is currently undervalued. However, should we believe this result?
To check the robustness of our relative valuation, let’s take a look at if CHKP shares a similar capital structure with the overall Software industry. This is especially important since we are using the P/E ratio, which is ineffective when comparing two entities with dramatically differing capital structures. With no debt, CHKP’s D/E ratio is significantly different from the average firm in the Software industry, which has a D/E ratio of 78.72%. In this case, rather than using a price multiple like P/E, we could resolve this issue by using an enterprise multiple like EV/EBITDA, which is immune from being influenced by differing capital structures.
What Model Should I Listen To?
Unfortunately, both models have their own merits and deficiencies, which means the truth lies somewhere in the middle. Relative valuation is computationally simple but exposed to market irrationality, which undermines its usefulness. Conversely, intrinsic valuation is immune from these factors but heavily affected by human forecasting errors. Instead of listening to one model over another, I encourage you to calculate a weighted average target share price based off both, applying a higher weight to the valuation method you think is more appropriate.
For CHKP, I’ve put together three important aspects you should further examine:
- Financial Health: Does CHKP 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 CHKP’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 CHKP? 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 US 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.