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Calculating The Intrinsic Value Of Zscaler, Inc. (NASDAQ:ZS)

Today we will run through one way of estimating the intrinsic value of Zscaler, Inc. (NASDAQ:ZS) by projecting its future cash flows and then discounting them to today's value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. 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. 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 Zscaler

The Calculation

We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. 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 discount the value of these future cash flows to their estimated value in today's dollars:

10-year free cash flow (FCF) estimate

2023

2024

2025

2026

2027

2028

2029

2030

2031

2032

Levered FCF ($, Millions)

US$329.5m

US$462.4m

US$627.2m

US$854.0m

US$1.13b

US$1.34b

US$1.53b

US$1.68b

US$1.81b

US$1.92b

Growth Rate Estimate Source

Analyst x21

Analyst x20

Analyst x15

Analyst x3

Analyst x3

Est @ 18.62%

Est @ 13.63%

Est @ 10.13%

Est @ 7.69%

Est @ 5.97%

Present Value ($, Millions) Discounted @ 8.1%

US$305

US$396

US$496

US$625

US$766

US$840

US$883

US$900

US$896

US$878

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$7.0b

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 (2.0%) 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 8.1%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$1.9b× (1 + 2.0%) ÷ (8.1%– 2.0%) = US$32b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$32b÷ ( 1 + 8.1%)10= US$15b

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$22b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Compared to the current share price of US$132, the company appears about fair value at a 12% 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
dcf

The Assumptions

Now the most important inputs to a discounted cash flow are the discount rate, and of course, the actual 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 Zscaler 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 8.1%, which is based on a levered beta of 1.021. 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 Zscaler

Strength

  • Debt is not viewed as a risk.

Weakness

  • Shareholders have been diluted in the past year.

Opportunity

  • Forecast to reduce losses next year.

  • Has sufficient cash runway for more than 3 years based on current free cash flows.

  • Current share price is below our estimate of fair value.

Threat

  • Not expected to become profitable over the next 3 years.

Moving On:

Whilst important, the DCF calculation 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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Zscaler, there are three further items you should explore:

  1. Risks: Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Zscaler , and understanding these should be part of your investment process.

  2. Management:Have insiders been ramping up their shares to take advantage of the market's sentiment for ZS's future outlook? Check out our management and board analysis with insights on CEO compensation and governance factors.

  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. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.

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