Calculating The Fair Value Of Altium Limited (ASX:ALU)

Key Insights

• Altium's estimated fair value is AU$43.78 based on 2 Stage Free Cash Flow to Equity

• Current share price of AU$44.72 suggests Altium is potentially trading close to its fair value

• Analyst price target for ALU is US$45.58, which is 4.1% above our fair value estimate

How far off is Altium Limited (ASX:ALU) from its intrinsic value? Using the most recent financial data, we'll take a look at whether the stock is fairly priced by projecting its future cash flows and then 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!

Companies can be valued in a lot of ways, so we would point out that a DCF is not perfect for every situation. If you want to learn more about discounted cash flow, the rationale behind this calculation can be read in detail in the Simply Wall St analysis model.

See our latest analysis for Altium

Step By Step Through The Calculation

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. 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.

A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, 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

	2024	2025	2026	2027	2028	2029	2030	2031	2032	2033
Levered FCF ($, Millions)	US$88.5m	US$106.7m	US$126.6m	US$151.6m	US$180.4m	US$201.6m	US$219.5m	US$234.4m	US$247.1m	US$258.0m
Growth Rate Estimate Source	Analyst x6	Analyst x6	Analyst x6	Analyst x3	Analyst x2	Est @ 11.77%	Est @ 8.86%	Est @ 6.83%	Est @ 5.40%	Est @ 4.41%
Present Value ($, Millions) Discounted @ 7.0%	US$82.7	US$93.1	US$103	US$115	US$128	US$134	US$136	US$136	US$134	US$131

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$1.2b

The second stage is also known as Terminal Value, this is the business's cash flow 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 have used the 5-year average of the 10-year government bond yield (2.1%) 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 7.0%.

Terminal Value (TV)= FCF₂₀₃₃ × (1 + g) ÷ (r – g) = US$258m× (1 + 2.1%) ÷ (7.0%– 2.1%) = US$5.3b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$5.3b÷ ( 1 + 7.0%)¹⁰= US$2.7b

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$3.9b. The last step is to then divide the equity value by the number of shares outstanding. Relative to the current share price of AU$44.7, the company appears around fair value at the time of writing. 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.

ASX:ALU Discounted Cash Flow January 5th 2024

The 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 Altium 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 7.0%, which is based on a levered beta of 0.991. 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.

SWOT Analysis for Altium

Strength

• Earnings growth over the past year exceeded the industry.

• Currently debt free.

Weakness

• Dividend is low compared to the top 25% of dividend payers in the Software market.

• Expensive based on P/E ratio and estimated fair value.

Opportunity

• Annual earnings are forecast to grow faster than the Australian market.

Threat

• Revenue is forecast to grow slower than 20% per year.

Next Steps:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching 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. If a company grows at a different rate, or if its cost of equity or risk free rate changes sharply, the output can look very different. For Altium, there are three further items you should consider:

1. Financial Health: Does ALU 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.

2. Future Earnings: How does ALU'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 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 Australian 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. 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.