Are EPAM Systems, Inc. (NYSE:EPAM) Investors Paying Above The Intrinsic Value?

How far off is EPAM Systems, Inc. (NYSE:EPAM) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by taking the foreast future cash flows of the company and discounting them back to today's value. I will use the Discounted Cash Flow (DCF) model. Don't get put off by the jargon, the math behind it is actually quite straightforward.

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. 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.

Check out our latest analysis for EPAM Systems

The calculation

We're using the 2-stage growth model, which simply means we take in account two stages of company's growth. In the initial period the company may have a higher growth rate and the second stage is usually assumed to have a stable growth rate. 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.

Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today's value:

10-year free cash flow (FCF) estimate

	2020	2021	2022	2023	2024	2025	2026	2027	2028	2029
Levered FCF ($, Millions)	$310.0m	$392.0m	$428.0m	$457.8m	$483.9m	$507.2m	$528.4m	$548.2m	$567.1m	$585.4m
Growth Rate Estimate Source	Analyst x2	Analyst x2	Analyst x1	Est @ 6.97%	Est @ 5.7%	Est @ 4.81%	Est @ 4.18%	Est @ 3.75%	Est @ 3.44%	Est @ 3.23%
Present Value ($, Millions) Discounted @ 8.62%	$285.4	$332.3	$334.0	$328.9	$320.1	$308.8	$296.2	$282.9	$269.5	$256.1

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF)= $3.0b

We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 10-year government bond rate (2.7%) 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 8.6%.

Terminal Value (TV) = FCF₂₀₂₉ × (1 + g) ÷ (r – g) = US$585m × (1 + 2.7%) ÷ (8.6% – 2.7%) = US$10b

Present Value of Terminal Value (PVTV) = TV / (1 + r)¹⁰ = $US$10b ÷ ( 1 + 8.6%)¹⁰ = $4.47b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is $7.48b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. This results in an intrinsic value estimate of $136.95. Compared to the current share price of $176.38, the company appears slightly overvalued at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.

Important assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 EPAM Systems 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 8.6%, which is based on a levered beta of 0.988. 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.

Next Steps:

Whilst important, DCF calculation shouldn’t be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. 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. What is the reason for the share price to differ from the intrinsic value? For EPAM Systems, I've put together three additional aspects you should further research:

1. Financial Health: Does EPAM 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.
2. Future Earnings: How does EPAM'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.
3. Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of EPAM? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NYSE every day. If you want to find the calculation for other stocks just search here.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.