Does Dynatrace, Inc. (NYSE: DT) stock price in May reflect what it is really worth? Today we’re going to estimate the intrinsic value of the stock by taking expected future cash flows and discounting them to present value. One way to do this is to use the Discounted Cash Flow (DCF) model. Before you think you won’t be able to figure it out, read on! It’s actually a lot less complex than you might imagine.
There are many ways that businesses can be valued, so we would like to stress that a DCF is not perfect for all situations. If you still have burning questions about this type of assessment, take a look at the Simply Wall St analysis model.
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Is Dynatrace valued enough?
We use what is called a 2-step model, which simply means that we have two different periods of growth rate for the cash flow of the business. Usually the first stage is higher growth and the second stage is lower growth stage. To begin with, we need to estimate the next ten years of cash flow. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or the last reported value. We assume that companies with decreasing free cash flow will slow their withdrawal rate, and companies with increasing free cash flow will see their growth rate slow down during this period. We do this to reflect that growth tends to slow down more in the early years than in the later years.
Typically, we assume that a dollar today is worth more than a dollar in the future, so we discount the value of those future cash flows to their estimated value in today’s dollars:
10-year free cash flow (FCF) estimate
|Levered FCF ($, million)||204.3 million USD||$ 257.2 million||325.7 million USD||$ 377.0 million||$ 420.8 million||$ 457.6 million||$ 488.3 million||514.2 million USD||$ 536.3 million||$ 555.6 million|
|Source of estimated growth rate||Analyst x13||Analyst x6||Analyst x10||Is 15.75%||Is at 11.62%||Is 8.73%||Is 6.71%||Is 5.29%||Is 4.3%||Is 3.61%|
|Present value ($, millions) discounted at 6.5%||192 USD||US $ 227||US $ 270||US $ 294||US $ 308||$ 314||$ 315||$ 312||US $ 306||US $ 297|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flow (PVCF) = 2.8 billion USD
The second stage is also known as terminal value, it is the cash flow of the business after 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 used the 5-year average of the 10-year government bond yield (2.0%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 6.5%.
Terminal value (TV)= FCF2030 × (1 + g) ÷ (r – g) = $ 556 million × (1 + 2.0%) ÷ (6.5% – 2.0%) = $ 13 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= 13 billion USD ÷ (1 + 6.5%)ten= $ 6.8 billion
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is US $ 9.6 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of US $ 44.5, the company appears potentially overvalued at the time of writing. Remember though, this is only a rough estimate, and like any complex formula – garbage in, garbage out.
We draw your attention to the fact that the most important data for a discounted cash flow is the discount rate and, of course, the actual cash flow. You don’t have to agree with these entries, I recommend that you redo the math yourself and play around with it. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view Dynatrace 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 takes into account debt. In this calculation, we used 6.5%, which is based on a leveraged beta of 0.945. Beta is a measure of the volatility of a stock, relative 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.
While a business valuation is important, it shouldn’t be the only metric you look at when researching a business. It is not possible to obtain an infallible valuation with a DCF model. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under / overvalued?” For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. Why is intrinsic value lower than the current share price? For Dynatrace, we’ve compiled three other things that you should take a closer look at:
- Risks: You should be aware of the 2 warning signs for Dynatrace we found out before considering an investment in the business.
- Future income: How does DT’s growth rate compare to its peers and to the market in general? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth forecast chart.
- Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high quality inventory to get a feel for what you might be missing!
PS. Simply Wall St updates its DCF calculation for every US stock every day, so if you want to find the intrinsic value of any other stock just search here.
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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take into account your goals or your financial situation. We aim to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative information. Simply Wall St has no position in any of the stocks mentioned.
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