An Intrinsic Calculation For Direct Digital Holdings, Inc. (NASDAQ:DRCT) Suggests It's 45% Undervalued
Key Insights
Direct Digital Holdings' estimated fair value is US$48.89 based on 2 Stage Free Cash Flow to Equity
Direct Digital Holdings is estimated to be 45% undervalued based on current share price of US$26.79
Analyst price target for DRCT is US$24.83 which is 49% below our fair value estimate
Today we'll do a simple run through of a valuation method used to estimate the attractiveness of Direct Digital Holdings, Inc. (NASDAQ:DRCT) as an investment opportunity by taking the expected future cash flows and discounting them to today's value. This will be done using the Discounted Cash Flow (DCF) model. Models like these may appear beyond the comprehension of a lay person, but they're fairly easy to follow.
Remember though, that there are many ways to estimate a company's value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
See our latest analysis for Direct Digital Holdings
Step By Step Through The Calculation
We are going to use a two-stage DCF model, which, as the name states, takes into account two stages of growth. The first stage is generally a higher growth period which levels off heading towards the terminal value, captured in the second 'steady growth' period. To begin with, we have to get estimates of the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
A DCF is all about the idea that a dollar in the future is less valuable than a dollar today, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) estimate
2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | 2033 | |
Levered FCF ($, Millions) | US$16.0m | US$20.1m | US$23.3m | US$26.0m | US$28.2m | US$30.2m | US$31.8m | US$33.3m | US$34.5m | US$35.7m |
Growth Rate Estimate Source | Analyst x1 | Analyst x1 | Est @ 15.53% | Est @ 11.56% | Est @ 8.78% | Est @ 6.83% | Est @ 5.47% | Est @ 4.51% | Est @ 3.85% | Est @ 3.38% |
Present Value ($, Millions) Discounted @ 6.3% | US$15.0 | US$17.8 | US$19.4 | US$20.4 | US$20.9 | US$21.0 | US$20.8 | US$20.5 | US$20.0 | US$19.5 |
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$195m
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. 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 (2.3%) 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 6.3%.
Terminal Value (TV)= FCF2033 × (1 + g) ÷ (r – g) = US$36m× (1 + 2.3%) ÷ (6.3%– 2.3%) = US$922m
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$922m÷ ( 1 + 6.3%)10= US$502m
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$698m. 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$26.8, the company appears quite undervalued at a 45% 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.
The Assumptions
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the 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 Direct Digital Holdings 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 6.3%, which is based on a levered beta of 0.862. 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 Direct Digital Holdings
Strength
Earnings growth over the past year exceeded the industry.
Weakness
Interest payments on debt are not well covered.
Opportunity
Annual revenue is forecast to grow faster than the American market.
Trading below our estimate of fair value by more than 20%.
Threat
Debt is not well covered by operating cash flow.
Looking Ahead:
Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won't be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Preferably you'd apply different cases and assumptions and see how they would impact the company's valuation. 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. What is the reason for the share price sitting below the intrinsic value? For Direct Digital Holdings, there are three relevant items you should look at:
Risks: We feel that you should assess the 2 warning signs for Direct Digital Holdings we've flagged before making an investment in the company.
Future Earnings: How does DRCT'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.
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.
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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.
