Key Insights
- Cerence's estimated fair value is US$48.98 based on 2 Stage Free Cash Flow to Equity
- Current share price of US$28.09 suggests Cerence is potentially 43% undervalued
- Our fair value estimate is 48% higher than Cerence's analyst price target of US$33.00
Today we will run through one way of estimating the intrinsic value of Cerence Inc. (NASDAQ:CRNC) by projecting its future cash flows and then discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.
We generally believe that a company's value is the present value of all of the cash it will generate in the future. However, a DCF is just one valuation metric among many, and it is not without flaws. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
View our latest analysis for Cerence
The Calculation
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) estimate
| 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | |
| Levered FCF ($, Millions) | US$4.71m | US$31.3m | US$104.7m | US$117.5m | US$137.0m | US$151.4m | US$163.5m | US$173.7m | US$182.3m | US$189.8m |
| Growth Rate Estimate Source | Analyst x4 | Analyst x4 | Analyst x2 | Analyst x2 | Analyst x1 | Est @ 10.52% | Est @ 7.99% | Est @ 6.21% | Est @ 4.97% | Est @ 4.10% |
| Present Value ($, Millions) Discounted @ 8.8% | US$4.3 | US$26.4 | US$81.3 | US$83.9 | US$90.0 | US$91.4 | US$90.8 | US$88.6 | US$85.5 | US$81.8 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$724m
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. For a number of reasons a very conservative growth rate is used that cannot exceed that of a country's GDP growth. In this case we have used the 5-year average of the 10-year government bond yield (2.1%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 8.8%.
Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$190m× (1 + 2.1%) ÷ (8.8%– 2.1%) = US$2.9b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$2.9b÷ ( 1 + 8.8%)10= US$1.2b
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$2.0b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$28.1, the company appears quite good value at a 43% 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
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 Cerence 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 8.8%, which is based on a levered beta of 1.128. 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 Cerence
- Debt is well covered by .
- Interest payments on debt are not well covered.
- Shareholders have been diluted in the past year.
- Forecast to reduce losses next year.
- Good value based on P/S ratio and estimated fair value.
- Debt is not well covered by operating cash flow.
Next Steps:
Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. It's not possible to obtain a foolproof valuation with a DCF model. 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 Cerence, we've compiled three important factors you should explore:
- Risks: For example, we've discovered 2 warning signs for Cerence that you should be aware of before investing here.
- Future Earnings: How does CRNC'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 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 NASDAQGS every day. If you want to find the calculation for other stocks just search here.
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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.
About NasdaqGS:CRNC
Cerence
Provides AI powered virtual assistants for the mobility/transportation market in the United States, rest of the Americas, Germany, rest of Europe, the Middle East, Africa, Japan, and rest of the Asia-Pacific.
Undervalued with moderate growth potential.
