How far is Roku, Inc. (NASDAQ: ROKU) from its intrinsic worth? Using the most recent financial data, we’ll examine whether the stock’s price is fair by taking expected future cash flows and discounting them to their present value. To this end, we will take advantage of the Discounted Cash Flow (DCF) model. There really isn’t much to it, although it might seem quite complex.

There are many ways businesses can be assessed, so we would like to point out that a DCF is not perfect for all situations. If you want to know more about discounted cash flow, the rationale for this calculation can be read in detail in the Simply Wall St.

See our latest review for Roku

What is the estimated valuation?

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. In the first step, we have to estimate the cash flow of the business over the next ten years. 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.

In general, 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:

10-year Free Cash Flow (FCF) estimate

(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 12 billion

After calculating the present value of future cash flows over the initial 10 year period, we need to calculate the terminal value, which takes into account all future cash flows beyond the first step. 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 6.7%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = US $ 3.2B × (1 + 2.0%) ÷ (6.7% – 2.0%) = US $ 69B

Present value of terminal value (PVTV)= TV / (1 + r)^ten= US $ 69 billion ÷ (1 + 6.7%)^ten= 36 billion US dollars

The total value is the sum of the cash flows for the next ten years plus the final present value, which gives the total value of equity, which in this case is US $ 48 billion. The last step is then to divide the equity value by the number of shares outstanding. Compared to the current share price of US $ 436, the company appears to be around fair value at the time of writing. Remember, however, that this is only a rough estimate, and like any complex formula – trash in, trash out.

Important assumptions

Now the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flow. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play 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 Roku 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 into account debt. In this calculation, we used 6.7%, which is based on a leveraged beta of 0.992. 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.

Looking forward:

While a business valuation is important, it shouldn’t be the only metric you look at when researching a business. It is not possible to achieve a rock-solid valuation with a DCF model. Instead, the best use of a DCF model is to test certain assumptions and theories to see if they would lead to undervaluation or overvaluation of the company. For example, if the terminal value growth rate is adjusted slightly, it can dramatically change the overall result. For Roku, we’ve put together three relevant factors that you should dig deeper into:

1. Risks: To do this, you need to know the 3 warning signs we spotted with Roku.
2. Management: Have insiders increased their shares to take advantage of market sentiment about ROKU’s future prospects? Check out our management and board analysis with information on CEO compensation and governance factors.
3. Other strong companies: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid trading fundamentals to see if there are other companies you might not have considered!

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

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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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