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Choosing the right financial tool to evaluate a company can be a daunting task, especially when different models are giving you drastically different conclusions. A prime example of conflicts between valuation models is Momo Inc’s (NASDAQ:MOMO). While my discounted cash flow (DCF) model tells me that it is undervalued by 13.35%, my relative valuation model says it is overvalued by 71.41%. Which model do I listen to and more importantly why?
Deep-dive into intrinsic valuation
Forecasting anything into the distant future is difficult and the same applies to forecasting free cash flows (FCFs) for businesses. This is why I’ve decided to use analyst FCF forecasts in my DCF to see what the consensus view is while also removing some subjectivity. If you’re unfamiliar with valuation, the assumption behind every DCF is that a firm’s true value is derived from the sum of all its future FCFs, which is why quality forecasts are important. To obtain the per share intrinsic value of MOMO, we must first discount the sum of MOMO’s future FCFs by 11.5%, which gives us an equity value of $7.67B. Dividing by 198.58M shares outstanding, we get an intrinsic share price of $38.64. This means that the average broker analyst believes that MOMO’s true value should be closer to $38.64 vs its current price of $33.48. Take a look at how I arrived at this intrinsic value here.,
But is this value reliable? One quick check we can do is to see how many analyst forecasts have been incorporated into the final year of our forecast horizon, which is 5 years in MOMO’s case. Given there are only 2 analyst projections of MOMO’s FCF in year 5, our model highlights that it is often really difficult to accurately forecast FCFs that far out into the future. Ultimately, not having enough forecasts for the final year weakens the conclusions our DCF draws on MOMO, which means we may want to put less significance on our model when determining a target price.
Examining relative valuation
While DCF models sum up future FCFs, relative valuation models are based on the idea that investors should pay the same price for two companies with identical risk and return profiles. Since the biggest dilemma is finding companies that are similar to MOMO, a viable proxy would be the overall Internet industry itself. By multiplying MOMO’s earnings by the industry’s P/E ratio, we can imply a true value of $9.57, which is a 71.41% overvaluation but is this a reliable conclusion?
To check the robustness of our relative valuation, let’s take a look at if MOMO has a similar growth profile to the overall Internet industry. With a projected earnings growth rate of 12.35% for next year, MOMO has a similar growth profile when compared with the Internet industry, which is projected to grow at 11.02%. This demonstrates that the Internet industry is a good proxy for MOMO and ideal for our relative valuation.
What Model Should I Listen To?
Unfortunately, both models have their own merits and deficiencies, which means the truth lies somewhere in the middle. Relative valuation is computationally simple but exposed to market irrationality, which undermines its usefulness. Conversely, intrinsic valuation is immune from these factors but heavily affected by human forecasting errors. Given the pros and cons that I have laid out, I encourage you to derive a valuation by calculating a weighted average share price by using both models.
For MOMO, I’ve put together three key aspects you should look at:
Financial Health: Does MOMO 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.
Future Earnings: How does MOMO’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 High Quality Alternatives: Are there other high quality stocks you could be holding instead of MOMO? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. Simply Wall St does a DCF calculation for every US stock every 6 hours, so if you want to find the intrinsic value of any other stock just search here.
To help readers see pass the short term volatility of the financial market, we aim to bring you a long-term focused research analysis purely driven by fundamental data. Note that our analysis does not factor in the latest price sensitive company announcements.
The author is an independent contributor and at the time of publication had no position in the stocks mentioned.