Crunching the numbers
I use what is known as a 2-stage model, which simply means we have two different periods of varying growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a more stable growth phase. In the first stage we need to estimate the cash flows to the business over the next five years. For this I used the consensus of the analysts covering the stock, as you can see below. The sum of these cash flows is then discounted to today’s value.
5-year cash flow estimate
| 2018 | 2019 | 2020 | 2021 | 2022 | |
| Levered FCF ($, Millions) | $-25.39 | $-16.53 | $3.50 | $23.50 | $25.90 |
| Source | Analyst x2 | Analyst x2 | Analyst x1 | Analyst x1 | Analyst x1 |
| Present Value Discounted @ 9.5% | $-23.19 | $-13.78 | $2.67 | $16.35 | $16.45 |
Present Value of 5-year Cash Flow (PVCF)= $-1.50
The second stage is also known as Terminal Value, this is the business’s cash flow after the first stage. For a number of reasons a very conservative growth rate is used that cannot exceed that of the GDP. In this case I have used the 10-year government bond rate (2.9%). In the same way as with the 5-year ‘growth’ period, we discount this to today’s value at a cost of equity of 9.5%.
Terminal Value (TV) = FCF2022 × (1 + g) ÷ (r – g) = $25.90 × (1 + 2.9%) ÷ (9.5% – 2.9%) = $407.25
Present Value of Terminal Value (PVTV) = TV / (1 + r)5 = $407.25 / ( 1 + 9.5%)5 = $258.73
The total value, or equity value, is then the sum of the present value of the cash flows, which in this case is $257.23. In the final step we divide the equity value by the number of shares outstanding. If the stock is an depositary receipt (represents a specified number of shares in a foreign corporation) or ADR then we use the equivalent number. This results in an intrinsic value of $22.77. Compared to the current share price of $28.7, the stock is fair value, maybe slightly overvalued and not available at a discount at this time.
The 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 my inputs, I recommend redoing the calculations yourself and playing with them. Because we are looking at Digimarc as potential shareholders, the cost of equity is used as the discount rate, rather than the cost of capital (or weighed average cost of capital, WACC) which accounts for debt. In this calculation I’ve used 9.5%, which is based on a levered beta of 0.929. This is derived from the Bottom-Up Beta method based on comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
Next Steps:
Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. What is the reason for the share price to differ from the intrinsic value? For DMRC, there are three essential aspects you should look at:
- Financial Health: Does DMRC 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 DMRC’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 DMRC? 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.