How far is Paylocity Holding Corporation (NASDAQ:PCTY) 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. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. This may sound complicated, but it’s actually quite simple!

Businesses can be valued in many ways, which is why we emphasize that a DCF is not perfect for all situations. For those who are passionate about stock analysis, the Simply Wall St analysis template here may interest you.

See our latest analysis for Paylocity Holding

crush numbers

We use what is called a 2-step model, which simply means that we have two different periods of company cash flow growth rates. Generally, the first stage is a higher growth phase and the second stage is a lower growth phase. To begin with, we need to obtain cash flow estimates for 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, and so the sum of these future cash flows is then discounted to today’s value:

Estimated free cash flow (FCF) over 10 years

(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $3.3 billion

We now need to calculate the terminal value, which represents 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 10-year government bond yield of 2.0%. We discount terminal cash flows to present value at a cost of equity of 6.2%.

Terminal value (TV)= FCF₂₀₃₁ × (1 + g) ÷ (r – g) = $779 million × (1 + 2.0%) ÷ (6.2%–2.0%) = $19 billion

Present value of terminal value (PVTV)= TV / (1 + r)^ten= $19 billion ÷ (1 + 6.2%)^ten= $10 billion

The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is $13 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of US$196, the company appears to be about fair value at a 19% discount to the current share price. The assumptions of any calculation have a big impact on the valuation, so it’s best to consider this as a rough estimate, not accurate down to the last penny.

The hypotheses

Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flows. 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, nor the future capital needs of a company, so it does not give a complete picture of a company’s potential performance. Since we view Paylocity Holding 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 6.2%, which is based on a leveraged beta of 0.976. 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.

Look forward:

Although important, the DCF calculation is just one of many factors you need to assess for a business. The DCF model is not a perfect stock valuation tool. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under/overvalued?” If a company grows at a different pace, or if its cost of equity or risk-free rate changes sharply, output may be very different. For Paylocity Holding, we’ve compiled three relevant things you should dig into:

1. Risks: You should be aware of the 1 warning sign for Paylocity Holding we found out before considering an investment in the business.
2. Future earnings: How does PCTY’s growth rate compare to its peers and the broader market? Dive deeper into the analyst consensus figure for the coming years by interacting with our free analyst growth forecast chart.
3. Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high-quality actions to get an idea of ​​what you might be missing!

PS. Simply Wall St updates its DCF calculation for every US stock daily, so if you want to find the intrinsic value of any other stock, do a search here.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.