The intrinsic value of Paychex, Inc. (NASDAQ:PAYX) is potentially 33% higher than its stock price
How far is Paychex, Inc. (NASDAQ:PAYX) from its intrinsic value? Using the most recent financial data, we will examine whether the stock price is fair by taking expected future cash flows and discounting them to their present value. The Discounted Cash Flow (DCF) model is the tool we will apply to do this. 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.
See our latest analysis for Paychex
We will use a two-stage DCF model which, as the name suggests, takes into account two stages of growth. The first stage is usually a period of higher growth which stabilizes towards the terminal value, captured in the second period of “sustained growth”. 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.
A DCF is based on the idea that a dollar in the future is worth less than a dollar today, and so the sum of these future cash flows is then discounted to today’s value:
10-Year Free Cash Flow (FCF) Forecast
|Leveraged FCF ($, millions)||$1.91 billion||$1.83 billion||US$2.12 billion||US$2.26 billion||$2.42 billion||$2.54 billion||$2.64 billion||$2.73 billion||$2.81 billion||$2.89 billion|
|Growth rate estimate Source||Analyst x3||Analyst x3||Analyst x2||Analyst x1||Analyst x1||Is at 4.96%||Is at 4.05%||Is at 3.42%||Is 2.98%||Is at 2.66%|
|Present value (millions of dollars) discounted at 6.2%||$1.8,000||$1,600||$1.8,000||$1.8,000||$1.8,000||$1.8,000||$1.7,000||$1.7,000||$1,600||$1,600|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $17 billion
We now need to calculate the terminal value, which represents all future cash flows after this ten-year period. For a number of reasons, a very conservative growth rate is used which cannot exceed that of a country’s GDP growth. In this case, we used the 5-year average of the 10-year government bond yield (1.9%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to present value, using a cost of equity of 6.2%.
Terminal value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$2.9 billion × (1 + 1.9%) ÷ (6.2%–1.9%) = US$69 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= $69 billion ÷ (1 + 6.2%)ten= $38 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 $55 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of US$115, the company looks slightly undervalued at a 25% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.
We emphasize that 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 consider Paychex 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 6.2%, which is based on a leveraged beta of 1.003. 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.
While a business valuation is important, it shouldn’t be the only metric to consider when researching a business. DCF models are not the be-all and end-all of investment valuation. Rather, it should be seen as a guide to “what assumptions must be true for this stock to be under/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 Paychex, we’ve put together three relevant factors you should explore:
- Risks: We believe that you should evaluate the 1 warning sign for Paychex we reported before investing in the company.
- Future earnings: How does PAYX’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 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.
Feedback on this article? Concerned about content? Get in touch with us directly. You can also email the editorial team (at) Simplywallst.com.
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.
Valuation is complex, but we help make it simple.
Find out if Payment is potentially overvalued or undervalued by viewing our full analysis, which includes fair value estimates, risks and warnings, dividends, insider trading and financial health.
See the free analysis