Knowing which valuation model to use for financial analysis can be incredibly confusing for even the most seasoned of investors. In the case of Accenture plc’s (NYSE:ACN), my discounted cash flow (DCF) model tells me that Accenture plc’s (NYSE:ACN) is overvalued by 9.37%; however, my relative valuation metrics tell me that Accenture plc’s (NYSE:ACN) is overvalued by 0.36%. Which model do I listen to and more importantly why?
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Examining intrinsic valuation
The DCF model follows the principle that a firm’s “true” value today is equal to the sum of all its the future free cash flows (FCF) it will make in the future (to infinity). Since the hardest part of constructing a DCF is forecasting this, I’ve decided to use the average expected FCF forecasted by broker analysts in my model. After discounting the sum of ACN’s future FCFs by 10%, it’s equity value comes to $US$85b, then 637.45k shares outstanding are divided through. This results in an intrinsic value of $133.7. Check out the source of my intrinsic value here.,
Before we move on, let’s evaluate whether this number is accurate. A key assumption in DCFs is that by the final year of our forecast horizon, which is year 5 in ACN’s case, a company is assumed to be mature and therefore FCF should be growing at a sustainable rate. ACN’s final year FCF growth rate of -3.14%, is too low. If this assumption held true, ACN 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. The downside is that forecasts are less reliable the further into the future they are.
Deep-dive into relative valuation
The assumption behind relative valuation is that two companies with similar risk-return characteristics should have the same price since investors theoretically would be indifferent to purchasing either company. Unfortunately, the hardest part is finding companies that are similar enough to ACN to compare it against. As such, I’ve used the overall IT industry as ACN’s proxy. The calculations for relative valuation are quite simple. By multiplying ACN’s earnings by the industry’s P/E ratio, we can obtain ACN’s fair value of $145.7, which tells us that it is overvalued. However, should we believe this result?
One quick way of finding out is to see if ACN shares a similar growth profile to the overall IT industry we are comparing it to. With a projected earnings growth rate of 11.42% for next year, ACN has a similar growth profile when compared with the IT industry, which is projected to grow at 12.45%. This demonstrates that the IT industry is a good proxy for ACN and ideal for our relative valuation.
Which Model Should I Care About?
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 ACN, I’ve compiled three important aspects you should further examine:
- Financial Health: Does ACN 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 ACN’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 ACN? 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 firstname.lastname@example.org.