How far is Sapiens International Corporation NV (NASDAQ:SPNS) from its intrinsic value? Using the most recent financial data, we will examine whether the stock price is fair by taking the expected future cash flows and discounting them to the present value. This will be done using the discounted cash flow (DCF) model. Before you think you can’t figure it out, just read on! It’s actually a lot less complex than you might imagine.
We generally believe that the value of a company is the present value of all the cash it will generate in the future. However, a DCF is just one of many evaluation metrics, and it is not without its flaws. Anyone interested in learning a little more about intrinsic value should read the Simply Wall St Analysis Template.
Step by step in the calculation
We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “sustained growth”. In the first step, we need to estimate the company’s cash flow over the next ten years. Wherever possible, we use analysts’ estimates, but where these are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction and companies with increasing free cash flow will see their growth rate slow during this period. We do this to reflect the fact that growth tends to slow more in early years than in later years.
Generally, we assume that a dollar today is worth more than a dollar in the future, so we discount the value of these future cash flows to their estimated value in today’s dollars:
Estimated free cash flow (FCF) over 10 years
|Leveraged FCF ($, millions)||$71.0 million||$85.0 million||$95.0 million||$103.5 million||$110.5 million||$116.4 million||$121.4 million||$125.8 million||$129.8 million||$133.4 million|
|Growth rate estimate Source||Analyst x1||Analyst x1||Is at 11.82%||Is at 8.86%||Is at 6.79%||Is at 5.34%||Is at 4.33%||Is at 3.62%||Is at 3.12%||Is at 2.77%|
|Present value (millions of dollars) discounted at 7.1%||$66.3||$74.1||$77.4||$78.7||$78.4||$77.2||$75.2||$72.7||$70.0||$67.2|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $737 million
We now need to calculate the terminal value, which represents all future cash flows after this ten-year period. For a number of reasons, a very conservative growth rate is used which cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (2.0%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 7.1%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = $133 million × (1 + 2.0%) ÷ (7.1%–2.0%) = $2.6 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= $2.6 billion ÷ (1 + 7.1%)ten= $1.3 billion
The total value is the sum of the cash flows for the next ten years plus the present terminal value, which gives the total equity value, which in this case is $2.1 billion. The final step is to divide the equity value by the number of shares outstanding. Based on the current share price of $34.2, the company appears to be approximately fair value at a 9.4% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.
We emphasize 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 entries, I recommend that you redo the calculations yourself and play around with them. The DCF also does not take into account the possible cyclicality of an industry or the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we consider Sapiens International 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 takes debt into account. In this calculation, we used 7.1%, which is based on a leveraged beta of 1.033. Beta is a measure of a stock’s volatility relative to the market as a whole. We derive our beta from the average industry beta of broadly comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.
Valuation is only one side of the coin in terms of building your investment thesis, and it ideally won’t be the only piece of analysis you look at for a company. It is not possible to obtain an infallible valuation with a DCF model. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. For example, if the terminal value growth rate is adjusted slightly, it can significantly change the overall result. For Sapiens International, we have compiled three relevant aspects that you should consider in more detail:
- Financial health: Does SPNS have a healthy balance sheet? Take a look at our free balance sheet analysis with six simple checks on key factors such as leverage and risk.
- Future earnings: How does the growth rate of SPNS compare to its peers and the market in general? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
- Other high-quality alternatives: Do you like a good all-rounder? To explore our interactive list of high-quality actions to get an idea of what else you might be missing!
PS. The Simply Wall St app performs a daily updated cash flow assessment for each NASDAQGS stock. If you want to find the calculation for other stocks just search here.
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