How far is Guidewire Software, Inc. (NYSE:GWRE) removed from its net asset value? Using the most recent financial data, we’ll see if the stock is reasonably priced by taking projected future cash flows and discounting them to their present value. For this we use the Discounted Cash Flow (DCF) model. Before you think you won’t understand, just read on! It’s actually a lot less complicated than you might think.
We generally believe that the value of a company is the present value of all the money it will generate in the future. However, a DCF is only one of many valuation metrics and is not without flaws. For those who like to learn about stock analysis, the Simply Wall St analysis model here may be of interest to you.
Check out our latest analysis for Guidewire Software
The calculation
We use the 2-stage growth model, which simply means that we consider two stages of the company’s growth. In the initial period, the company may have a higher growth rate, and in the second stage, it is usually assumed to have a stable growth rate. In the first phase, we have to estimate the cash flows to the company over the next ten years. Where possible, we use analyst estimates, but if they are not available, we extrapolate the previous free cash flow (FCF) from the latest estimate or reported value. We assume that companies with shrinking free cash flow will slow their rate of shrinkage, and companies with growing free cash flow will slow their rate of growth over this period. We do this to indicate that growth slows more in the early years than in later years.
A DCF is all about the idea that a dollar in the future will be worth less than a dollar today, so we discount the value of these future cash flows to their estimated value in today’s dollars:
10-year Free Cash Flow (FCF) forecast
| 2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | |
| Levered FCF ($, millions) | US$43.0 million | US$103.5m | US$160.7m | US$221.4 million | US$291.7m | US$344.8m | US$390.8m | US$429.6m | US$461.9m | US$489.0m |
| Source estimate growth rate | Analyst x8 | Analyst x5 | Analyst x2 | Analyst x1 | Analyst x1 | Estimated @ 18.23% | Estimated @ 13.34% | Estimated @ 9.92% | Estimated @ 7.53% | Estimated @ 5.85% |
| Present value ($, millions) discounted @ 6.3% | €40.4 | US$91.5 | €134 | $173 | €215 | US$239 | US$254 | $263 | US$266 | US$265 |
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-Year Cash Flow (PVCF) = US$1.9 billion
After calculating the present value of future cash flows in the first 10-year period, we need to calculate the terminal value, which represents all future cash flows after the first stage. The Gordon Growth Formula is used to calculate Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 1.9%. We discount the terminal cash flows to present value at a cost of equity of 6.3%.
Final value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$489m× (1 + 1.9%) ÷ (6.3%–1.9%) = US$11b
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$11b÷ (1 + 6.3%)10= US$6.1 billion
The total value, or asset value, is then the sum of the present value of the future cash flows, in this case US$8.1 billion. The final step is to then divide the value of equity by the number of shares outstanding. Compared to its current share price of $72.3, the company appears slightly undervalued at a 25% discount from where the share price is currently trading. The assumptions in any calculation have a big impact on the valuation, so it’s better to think of this as a rough estimate, not accurate to the last cent.
The assumptions
Now the main inputs to a discounted cash flow are the discount rate and of course the actual cash flows. You don’t have to agree with this input, I recommend redoing the calculations yourself and playing with it. The DCF also does not take into account the potential cyclicality of an industry or a company’s future capital requirements, so it does not provide a complete picture of a company’s potential performance. Since we consider Guidewire Software 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) that takes into account debt. In this calculation, we used 6.3%, which is based on a levered beta of 1.035. Beta is a measure of the volatility of a stock compared to the market as a whole. We get our beta from the industry-average beta of globally comparable companies, with an imposed cap between 0.8 and 2.0, which is a reasonable range for a stable company.
Next steps:
Valuation is only one side of the coin when it comes to crafting your investment thesis, and ideally it shouldn’t be the only piece of analysis you’re looking at for a company. DCF models are not everything to do with investment valuation. Instead, it’s best to use a DCF model to test certain assumptions and theories to see if they would cause the company to be undervalued or overvalued. If a company grows at a different pace, or if the cost of equity or risk-free interest rates change dramatically, the output can look very different. Why is the share price below its net asset value? For Guidewire Software, we have compiled three fundamental aspects that you should examine:
- risks: Consider, for example, the ever-present specter of investment risk. We have identified 2 warning signs with Guidewire Software, and understanding it should be part of your investment process.
- Future Profit: How does GWRE’s growth rate compare to its competitors and the broader market? Dig deeper into the analyst consensus figure for years to come by using our free analyst growth forecast chart.
- Other high-quality alternatives: Do you like a good all-rounder? Explore our interactive list of high quality stocks to get an idea of what else you might be missing!
ps. The Simply Wall St app performs a discounted cash flow valuation for every stock on the NYSE every day. To find the calculation for other stocks, all you need to do is search here.
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This article from Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended as financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your objectives or your financial situation. We strive to provide you with long-term focused analysis powered by fundamental data. Please note that our analysis may not take into account the latest price-sensitive company announcements or quality material. Simply Wall St has no position in said stocks.
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