Estimating The Intrinsic Value Of Sprout Social, Inc. (NASDAQ:SPT)

Key Insights

• The projected fair value for Sprout Social is US$50.08 based on 2 Stage Free Cash Flow to Equity

• Sprout Social's US$47.56 share price indicates it is trading at similar levels as its fair value estimate

• Our fair value estimate is 19% lower than Sprout Social's analyst price target of US$62.09

Today we will run through one way of estimating the intrinsic value of Sprout Social, Inc. (NASDAQ:SPT) by projecting its future cash flows and then discounting them to today's value. This will be done using 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.

Check out our latest analysis for Sprout Social

Crunching The Numbers

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.

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) forecast

	2023	2024	2025	2026	2027	2028	2029	2030	2031	2032
Levered FCF ($, Millions)	US$20.8m	US$31.7m	US$62.5m	US$82.4m	US$132.0m	US$162.3m	US$189.4m	US$212.7m	US$232.4m	US$248.9m
Growth Rate Estimate Source	Analyst x6	Analyst x8	Analyst x2	Est @ 31.87%	Analyst x1	Est @ 22.94%	Est @ 16.69%	Est @ 12.32%	Est @ 9.25%	Est @ 7.11%
Present Value ($, Millions) Discounted @ 8.1%	US$19.2	US$27.2	US$49.5	US$60.5	US$89.6	US$102	US$110	US$114	US$116	US$115

("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$803m

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. 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 2.1%. We discount the terminal cash flows to today's value at a cost of equity of 8.1%.

Terminal Value (TV)= FCF₂₀₃₂ × (1 + g) ÷ (r – g) = US$249m× (1 + 2.1%) ÷ (8.1%– 2.1%) = US$4.3b

Present Value of Terminal Value (PVTV)= TV / (1 + r)¹⁰= US$4.3b÷ ( 1 + 8.1%)¹⁰= US$2.0b

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$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$47.6, the company appears about fair value at a 5.0% discount to where the stock price trades currently. Valuations are imprecise instruments though, rather like a telescope - move a few degrees and end up in a different galaxy. Do keep this in mind.

dcf

Important Assumptions

We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 Sprout Social 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 1.000. 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 Sprout Social

Strength

• Currently debt free.

Weakness

• No major weaknesses identified for SPT.

Opportunity

• 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:

Although the valuation of a company is important, it shouldn't be the only metric you look at when researching a company. The DCF model is not a perfect stock valuation tool. Rather it should be seen as a guide to "what assumptions need to be true for this stock to be under/overvalued?" For instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Sprout Social, there are three pertinent elements you should consider:

1. Risks: For example, we've discovered 1 warning sign for Sprout Social that you should be aware of before investing here.

2. Future Earnings: How does SPT'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 American stock every day, so if you want to find the intrinsic value of any other stock 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.

Join A Paid User Research Session
You’ll receive a US$30 Amazon Gift card for 1 hour of your time while helping us build better investing tools for the individual investors like yourself. Sign up here