Is NetScout Systems, Inc. (NASDAQ:NTCT) Trading At A 43% Discount?

Key Insights

• The projected fair value for NetScout Systems is US$38.59 based on 2 Stage Free Cash Flow to Equity
• NetScout Systems' US$21.84 share price signals that it might be 43% undervalued

In this article we are going to estimate the intrinsic value of NetScout Systems, Inc. (NASDAQ:NTCT) by taking the expected future cash flows and discounting them to today's value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. There's really not all that much to it, even though it might appear quite complex.

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

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Is NetScout Systems Fairly Valued?

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. To begin with, we have to get estimates of the next ten years of cash flows. 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) forecast

	2025	2026	2027	2028	2029	2030	2031	2032	2033	2034
Levered FCF ($, Millions)	US$98.7m	US$119.8m	US$143.2m	US$137.9m	US$135.5m	US$134.9m	US$135.6m	US$137.2m	US$139.5m	US$142.3m
Growth Rate Estimate Source	Analyst x1	Analyst x1	Analyst x1	Est @ -3.71%	Est @ -1.77%	Est @ -0.41%	Est @ 0.54%	Est @ 1.20%	Est @ 1.66%	Est @ 1.99%
Present Value ($, Millions) Discounted @ 6.8%	US$92.4	US$105	US$117	US$106	US$97.3	US$90.7	US$85.3	US$80.8	US$76.9	US$73.4

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$925m

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 2.8%. We discount the terminal cash flows to today's value at a cost of equity of 6.8%.

Terminal Value (TV)= FCF₂₀₃₄ × (1 + g) ÷ (r – g) = US$142m× (1 + 2.8%) ÷ (6.8%– 2.8%) = US$3.6b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$3.6b÷ ( 1 + 6.8%)¹⁰= US$1.8b

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$2.8b. The last step is to then divide the equity value by the number of shares outstanding. Compared to the current share price of US$21.8, the company appears quite good value at a 43% 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.

Important Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual cash flows. Part of investing is coming up with your own evaluation of a company's future performance, so try the calculation yourself and check your own 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 NetScout 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 6.8%, which is based on a levered beta of 0.945. 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.

View our latest analysis for NetScout Systems

Next Steps:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. DCF models are not the be-all and end-all of investment valuation. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. For example, changes in the company's cost of equity or the risk free rate can significantly impact the valuation. What is the reason for the share price sitting below the intrinsic value? For NetScout Systems, we've compiled three important elements you should explore:

1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with NetScout Systems , and understanding this should be part of your investment process.
2. Future Earnings: How does NTCT'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. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NASDAQGS every day. If you want to find the calculation for other stocks just search here.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.