How far is Instructure Holdings, Inc. (NYSE:INST) from its intrinsic value? Using the most recent financial data, we will examine whether the stock price is fair by projecting its future cash flows and then discounting them to the present value. We will use the Discounted Cash Flow (DCF) model for this purpose. Don’t be put off by the jargon, the underlying calculations are actually quite simple.
Remember though that there are many ways to estimate the value of a business and a DCF is just one method. Anyone interested in learning a little more about intrinsic value should read the Simply Wall St Analysis Template.
What is the estimated value?
We use the 2-stage growth model, which simply means that we consider two stages of business growth. In the initial period, the company may have a higher growth rate, and the second stage is generally assumed to have a stable growth rate. 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 need to discount the sum of these future cash flows to arrive at an estimate of present value:
Estimated free cash flow (FCF) over 10 years
|Leveraged FCF ($, millions)||$184.2 million||$216.0 million||$239.3 million||$258.8 million||$275.1 million||$288.7 million||$300.5 million||$310.8 million||$320.1 million||$328.6 million|
|Growth rate estimate Source||Analyst x5||Analyst x1||Is at 10.8%||Is at 8.14%||Is at 6.28%||Is at 4.98%||Is at 4.07%||Is at 3.43%||Is 2.98%||Is at 2.67%|
|Present value (in millions of dollars) discounted at 6.5%||$173||$190||$198||$201||$200||$198||$193||$187||$181||$175|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $1.9 billion
The second stage is also known as the terminal value, it is the cash flow of the business after the first stage. The Gordon Growth formula is used to calculate the terminal value at a future annual growth rate equal to the 5-year average 10-year government bond yield of 1.9%. We discount terminal cash flows to present value at a cost of equity of 6.5%.
Terminal value (TV)= FCF2032 × (1 + g) ÷ (r – g) = $329 million × (1 + 1.9%) ÷ (6.5%–1.9%) = $7.3 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= $7.3 billion ÷ (1 + 6.5%)ten= $3.9 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 $5.8 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of $22.3, the company appears to be pretty good value at a 45% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.
Now, 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 view Instructure 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 factors in debt. In this calculation, we used 6.5%, which is based on a leveraged beta of 1.083. 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 crafting your investment thesis, and ideally it won’t be the only piece of analysis you look at for a company. DCF models are not the be-all and end-all of investment valuation. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to the company being undervalued or overvalued. For example, if the terminal value growth rate is adjusted slightly, it can significantly change the overall result. Why is intrinsic value higher than the current stock price? For Instructure Holdings, we’ve rounded up three more aspects for you to assess:
- Risks: Take risks, for example – Instructure Holdings has 3 warning signs we think you should know.
- Future earnings: How does INST’s growth rate 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 strong companies: Low debt, high returns on equity and good past performance are essential to a strong business. Why not explore our interactive list of stocks with strong trading fundamentals to see if there are any other businesses you may not have considered!
PS. Simply Wall St updates its DCF calculation daily for every US stock, so if you want to find the intrinsic value of any other stock, search here.
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