With so many different financial models generating different conclusions, choosing the most relevant one to value a company can be daunting. For instance, while my relative valuation model tells me Total System Services, Inc.’s (NYSE:TSS) is overvalued by 30.81%, my discounted cash flow (DCF) model signals a 25.34% overvaluation instead. Which model do I listen to and more importantly why?
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A closer look at 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. To obtain the per share intrinsic value of TSS, we must first discount the sum of TSS’s future FCFs by 12%, which gives us an equity value of $US$13b, then 182.44k shares outstanding are divided through. This results in an intrinsic value of $69.35. Check out the source of my intrinsic value here.,
But how accurate is this figure? A key assumption in DCFs is that by the final year of our forecast horizon, which is year 5 in TSS’s case, a company is assumed to be mature and therefore FCF should be growing at a sustainable rate. At -0.19%, final year FCF growth is unsustainably low. If this assumption held true, TSS 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. However, the trade-off is that there are less analyst forecasts the further in the future we go.
Deep-dive into relative valuation
The basic principle of relative valuation is that two companies with near identical characteristics should be priced similarly. But a big issue here is actually finding companies that are similar to TSS, so I’ve used the IT industry as a proxy. The calculations for relative valuation are quite simple. By multiplying TSS’s earnings by the industry’s P/E ratio, we can obtain TSS’s fair value of $60.15, which tells us that it is overvalued. However, should we believe this result?
One quick way of finding out is to see if TSS shares a similar growth profile to the overall IT industry we are comparing it to. With a projected earnings growth rate of -6.64% for next year, TSS has a significantly different growth profile when compared with the IT industry, which is projected to grow at 10.53%. Unfortunately, this check shows that the IT industry is a poor proxy for TSS, which weakens our relative valuation analysis. Instead, we could dramatically improve our analysis by hand-picking companies that share similar growth profiles with TSS. I’d encourage you to do this by taking a look at TSS’s competitors.
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 straightforward but prone to overall market mispricing. Meanwhile, intrinsic valuation is independent from market tendencies; however, is highly exposed to human error. Ultimately, investors should derive their final valuation based off both models. I encourage you to weight each model depending on your preferences to calculate a weighted average target price.
For TSS, I’ve compiled three key aspects you should look at:
- Financial Health: Does TSS 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 TSS’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 TSS? 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 email@example.com.