Extreme Networks, Inc. (NASDAQ:EXTR) Shares Could Be 39% Below Their Intrinsic Value Estimate

By
Simply Wall St
Published
February 02, 2021
NasdaqGS:EXTR
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Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Extreme Networks, Inc. (NASDAQ:EXTR) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. Our analysis will employ the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it is quite simple!

Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. For those who are keen learners of equity analysis, the Simply Wall St analysis model here may be something of interest to you.

Check out our latest analysis for Extreme Networks

The model

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 need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) estimate

2021 2022 2023 2024 2025 2026 2027 2028 2029 2030
Levered FCF ($, Millions) US$73.4m US$78.7m US$90.0m US$98.4m US$105.4m US$111.2m US$116.3m US$120.7m US$124.6m US$128.2m
Growth Rate Estimate Source Analyst x2 Analyst x2 Analyst x1 Est @ 9.29% Est @ 7.11% Est @ 5.59% Est @ 4.53% Est @ 3.78% Est @ 3.26% Est @ 2.89%
Present Value ($, Millions) Discounted @ 7.9% US$68.0 US$67.5 US$71.6 US$72.5 US$72.0 US$70.4 US$68.2 US$65.6 US$62.8 US$59.8

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$678m

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond the first stage. 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 5-year average of the 10-year government bond yield (2.0%) 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 7.9%.

Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$128m× (1 + 2.0%) ÷ (7.9%– 2.0%) = US$2.2b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$2.2b÷ ( 1 + 7.9%)10= US$1.0b

The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$1.7b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$8.6, the company appears quite good value at a 39% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf
NasdaqGS:EXTR Discounted Cash Flow February 3rd 2021

Important assumptions

The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. If you don't agree with these result, have a go at the calculation yourself and play with the assumptions. 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 Extreme Networks 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 7.9%, which is based on a levered beta of 1.124. 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.

Moving On:

Although the valuation of a company is important, it ideally won't be the sole piece of analysis you scrutinize for a company. It's not possible to obtain a foolproof valuation with a DCF model. Instead the best use for a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. What is the reason for the share price sitting below the intrinsic value? For Extreme Networks, there are three important factors you should explore:

  1. Risks: Every company has them, and we've spotted 3 warning signs for Extreme Networks (of which 1 makes us a bit uncomfortable!) you should know about.
  2. Future Earnings: How does EXTR'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: Do you like a good all-rounder? 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 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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Simply Wall St

Simply Wall St is focused on providing unbiased, high-quality research coverage on every listed company in the world. Our research team consists of data scientists and multiple equity analysts with over two decades worth of financial markets experience between them.