In this article, we’ll estimate the intrinsic value of Sprout Social, Inc. (NASDAQ: SPT) by taking the company’s future cash flow forecasts and discounting them to today’s value. Our analysis will use the discounted cash flow (DCF) model. Before you think you won’t be able to figure it out, read on! It’s actually a lot less complex than you might imagine.

We generally believe that the value of a business is the present value of all the cash it will generate in the future. However, a DCF is only one evaluation measure among many, and it is not without flaws. If you still have burning questions about this type of valuation, take a look at the Simply Wall St.

The method

We use what is called a two-step model, which simply means that we have two different periods of growth rate for the cash flow of the business. Usually, the first stage is higher growth, and the second stage is a lower growth stage. To begin with, we need to estimate the next ten years of cash flow. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated 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 down more in the early years than in subsequent years.

A DCF is based on the idea that a dollar in the future is worth less than a dollar today, so we discount the value of those future cash flows to their estimated value in today’s dollars. hui:

10-year Free Cash Flow (FCF) estimate

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = 720 million US dollars

We now need to calculate the Terminal Value, which takes into account all future cash flows after this ten year period. The Gordon growth formula is used to calculate the 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 their present value at a cost of equity of 6.5%.

Terminal value (TV)= FCF₂₀₃₀ × (1 + g) ÷ (r – g) = US $ 260 million × (1 + 2.0%) ÷ (6.5% to 2.0%) = US $ 5.9 billion

Present value of terminal value (PVTV)= TV / (1 + r)^ten= US $ 5.9 billion + (1 + 6.5%)^ten= US $ 3.2 billion

Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is $ 3.9 billion. The last step is then to divide the equity value by the number of shares outstanding. Compared to the current price of US $ 89.1, the company appears to be slightly overvalued at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it’s best to take this as a rough estimate, not precise down to the last penny.

NasdaqCM: SPT Discounted Cash Flow June 21, 2021

The hypotheses

Now the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. Part of investing is coming up with your own assessment of a company’s future performance, so try the math yourself and check your own assumptions. 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 Sprout Social 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 6.5%, which is based on a leveraged beta of 0.949. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our average beta from the industry beta of comparable companies globally, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable company.

To move on :

While a business valuation is important, it shouldn’t be the only metric you look at when researching a business. The DCF model is not a perfect equity valuation tool. 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 dramatically change the overall result. Why is intrinsic value lower than the current share price? For Sprout Social, we’ve put together three other areas you should explore:

1. Risks: As an example, we have found 3 warning signs for Sprout Social that you need to consider before investing here.
2. Future benefits: How does SPT’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus number for years to come by interacting with our free analyst growth expectations chart.
3. Other high quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality stocks to get a feel for what else you might be missing!

PS. The Simply Wall St app performs a daily discounted cash flow assessment for each NASDAQCM share. If you want to find the calculation for other actions, do a search here.

This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in any of the stocks mentioned.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.