Does the September share price for Medallia, Inc. (NYSE:MDLA) reflect what it’s really worth? Today, we will estimate the stock’s intrinsic value by projecting its future cash flows and then discounting them to today’s value. This will be done using the Discounted Cash Flow (DCF) model. Don’t get put off by the jargon, the math behind it is actually quite straightforward.
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.
Crunching the numbers
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. 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, so we discount the value of these future cash flows to their estimated value in today’s dollars:
10-year free cash flow (FCF) estimate
|Levered FCF ($, Millions)||-US$13.5m||US$17.3m||US$52.5m||US$87.0m||US$127.5m||US$169.9m||US$210.7m||US$247.4m||US$279.3m||US$306.4m|
|Growth Rate Estimate Source||Analyst x5||Analyst x5||Analyst x2||Est @ 65.64%||Est @ 46.61%||Est @ 33.3%||Est @ 23.97%||Est @ 17.45%||Est @ 12.88%||Est @ 9.68%|
|Present Value ($, Millions) Discounted @ 8.1%||-US$12.5||US$14.8||US$41.6||US$63.8||US$86.5||US$107||US$122||US$133||US$139||US$141|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$836m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.2%. We discount the terminal cash flows to today’s value at a cost of equity of 8.1%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$306m× (1 + 2.2%) ÷ (8.1%– 2.2%) = US$5.4b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$5.4b÷ ( 1 + 8.1%)10= US$2.5b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$3.3b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$27.4, 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.
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 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 Medallia 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 8.1%, which is based on a levered beta of 0.971. 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.
Although the valuation of a company is important, it 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?” For example, changes in the company’s cost of equity or the risk free rate can significantly impact the valuation. Can we work out why the company is trading at a premium to intrinsic value? For Medallia, we’ve compiled three essential items you should further research:
- Risks: We feel that you should assess the 4 warning signs for Medallia we’ve flagged before making an investment in the company.
- Future Earnings: How does MDLA’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. Simply Wall St updates its DCF calculation for every American stock every day, so if you want to find the intrinsic value of any other stock just search here.
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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. 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.
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