The intrinsic value of PayPal Holdings, Inc. (NASDAQ:PYPL) is potentially 70% higher than its stock price
Today we’ll walk through one way to estimate the intrinsic value of PayPal Holdings, Inc. (NASDAQ:PYPL) by taking expected future cash flows and discounting them to their present value. On this occasion, we will use the Discounted Cash Flow (DCF) model. Before you think you can’t figure it out, just read on! It’s actually a lot less complex than you might imagine.
We generally believe that the value of a company is the present value of all the cash it will generate in the future. However, a DCF is just one of many evaluation metrics, and it is not without its flaws. 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 analysis template.
See our latest analysis for PayPal Holdings
We use the 2-stage growth model, which simply means that we consider two stages of business growth. In the initial period, the company may have a higher growth rate, and the second stage is generally assumed to have a stable growth rate. 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.
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:
10-Year Free Cash Flow (FCF) Forecast
|Leveraged FCF ($, millions)||$7.33 billion||$8.54 billion||$8.48 billion||$8.38 billion||$8.36 billion||$8.40 billion||$8.47 billion||$8.57 billion||$8.69 billion||$8.83 billion|
|Growth rate estimate Source||Analyst x12||Analyst x8||Analyst x2||Analyst x2||Is @ -0.22%||Is at 0.43%||Is at 0.88%||Is at 1.2%||Is at 1.42%||Is at 1.58%|
|Present value (in millions of dollars) discounted at 6.4%||$6,900||$7,500||$7,100||$6.5,000||$6,100||$5,800||$5,500||$5,200||$5,000||$4.8,000|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $60 billion
The second stage is also known as the terminal value, it is the cash flow of the business after the first stage. 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 6.4%.
Terminal value (TV)= FCF2032 × (1 + g) ÷ (r – g) = $8.8 billion × (1 + 1.9%) ÷ (6.4%–1.9%) = $204 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= $204 billion ÷ (1 + 6.4%)ten= $110 billion
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is $170 billion. In the last step, we divide the equity value by the number of shares outstanding. Compared to the current share price of US$86.4, the company appears to be pretty good value at a 41% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.
Now, the most important inputs to a discounted cash flow are the discount rate and, of course, the actual cash flows. If you disagree with these results, try the math yourself and play around with the 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 consider PayPal Holdings 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 6.4%, which is based on a leveraged beta of 1.042. 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 important, calculating DCF shouldn’t be the only metric to consider when researching a business. It is not possible to obtain an infallible 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 the company being undervalued or overvalued. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on the valuation. Why is intrinsic value higher than the current stock price? For PayPal Holdings, you need to consider three additional factors:
- Risks: For example, we found 1 warning sign for PayPal Holdings that you must consider before investing here.
- Management:Did insiders increase their shares to take advantage of market sentiment about PYPL’s future prospects? View our management and board analysis with insights into CEO compensation and governance factors.
- Other strong companies: Low debt, high returns on equity and good past performance are essential to a strong business. Why not explore our interactive list of stocks with strong trading fundamentals to see if there are any other companies you may not have considered!
PS. The Simply Wall St app performs a daily updated cash flow assessment for each NASDAQGS stock. If you want to find the calculation for other stocks, 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.