Today we’ll do a simple run through of a valuation method used to estimate the attractiveness of Verisk Analytics, Inc. (NASDAQ:VRSK) as an investment opportunity by projecting its future cash flows and then discounting them to today’s value. We will use the Discounted Cash Flow (DCF) model on this occasion. 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. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
What’s the estimated valuation?
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 start off with, we need to estimate 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.
Generally we assume that a dollar today is more valuable than a dollar in the future, and so the sum of these future cash flows is then discounted to today’s value:
10-year free cash flow (FCF) estimate
|Levered FCF ($, Millions)||US$889.7m||US$1.01b||US$1.18b||US$1.28b||US$1.37b||US$1.45b||US$1.52b||US$1.57b||US$1.62b||US$1.67b|
|Growth Rate Estimate Source||Analyst x5||Analyst x5||Analyst x1||Est @ 9.18%||Est @ 7.04%||Est @ 5.54%||Est @ 4.49%||Est @ 3.75%||Est @ 3.24%||Est @ 2.88%|
|Present Value ($, Millions) Discounted @ 7.2%||US$830||US$881||US$955||US$972||US$971||US$956||US$932||US$902||US$868||US$833|
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$9.1b
We now need to calculate the Terminal Value, which accounts for all the future cash flows after this ten year period. The Gordon Growth formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.0%. We discount the terminal cash flows to today’s value at a cost of equity of 7.2%.
Terminal Value (TV)= FCF2030 × (1 + g) ÷ (r – g) = US$1.7b× (1 + 2.0%) ÷ (7.2%– 2.0%) = US$33b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$33b÷ ( 1 + 7.2%)10= US$16b
The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$26b. In the final step we divide the equity value by the number of shares outstanding. Relative to the current share price of US$172, the company appears around fair value at the time of writing. Remember though, that this is just an approximate valuation, and like any complex formula – garbage in, garbage out.
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 Verisk Analytics 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 7.2%, which is based on a levered beta of 0.987. 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.
Valuation is only one side of the coin in terms of building your investment thesis, and it shouldn’t be the only metric you look at when researching a company. It’s not possible to obtain a foolproof valuation with a DCF model. …