Today we will run through one way of estimating the intrinsic value of Zscaler, Inc. (NASDAQ:ZS) by taking the expected future cash flows and discounting them to their present value. This is done using 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. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.
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) estimate
|Levered FCF ($, Millions)||$25.5m||$64.0m||$97.5m||$155.3m||$237.2m||$302.8m||$363.8m||$418.1m||$465.3m||$505.8m|
|Growth Rate Estimate Source||Analyst x11||Analyst x12||Analyst x2||Analyst x2||Analyst x2||Est @ 27.64%||Est @ 20.17%||Est @ 14.93%||Est @ 11.27%||Est @ 8.71%|
|Present Value ($, Millions) Discounted @ 9.15%||$23.4||$53.7||$74.9||$109.4||$153.1||$179.0||$197.1||$207.5||$211.5||$210.7|
("Est" = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF)= $1.4b
The second stage is also known as Terminal Value, this is the business's cash flow after the first stage. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 10-year government bond rate of 2.7%. We discount the terminal cash flows to today's value at a cost of equity of 9.2%.
Terminal Value (TV) = FCF2029 × (1 + g) ÷ (r – g) = US$506m × (1 + 2.7%) ÷ (9.2% – 2.7%) = US$8.1b
Present Value of Terminal Value (PVTV) = TV / (1 + r)10 = $US$8.1b ÷ ( 1 + 9.2%)10 = $3.37b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is $4.79b. In the final step we divide the equity value by the number of shares outstanding. This results in an intrinsic value estimate of $38.12. Compared to the current share price of $49.59, the company appears potentially overvalued 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.
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. 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 9.2%, which is based on a levered beta of 1.078. 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.
Whilst important, DCF calculation 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?" 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 to differ from the intrinsic value? For Zscaler, I've put together three additional factors you should further research:
- Future Earnings: How does ZS'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.
- 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.
- Other High Quality Alternatives: Are there other high quality stocks you could be holding instead of ZS? Explore our interactive list of high quality stocks to get an idea of what else is out there you may be missing!
PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NASDAQ every day. If you want to find the calculation for other stocks just search here.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.