How far is Progress Software Corporation (NASDAQ: PRGS) of 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. This will be done using the discounted cash flow (DCF) model. Believe it or not, it’s not too hard to follow, as you’ll see in our example!
We draw your attention to the fact that there are many ways to value a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you want to know more about discounted cash flows, the rationale for this calculation can be read in detail in the Simply Wall St Analysis Template.
Check opportunities and risks within the US software industry.
What is the estimated value?
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. 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, so we need to discount the sum of these future cash flows to arrive at an estimate of present value:
Estimated free cash flow (FCF) over 10 years
2023 | 2024 | 2025 | 2026 | 2027 | 2028 | 2029 | 2030 | 2031 | 2032 | |
Leveraged FCF ($, millions) | $202.9 million | $219.2 million | $220.3 million | $229.1 million | $236.2 million | $242.8 million | $249.0 million | $254.9 million | $260.6 million | $266.3 million |
Growth rate estimate Source | Analyst x3 | Analyst x2 | Analyst x1 | Analyst x1 | Is at 3.12% | Is at 2.78% | Is at 2.54% | Is at 2.37% | Is at 2.25% | Is at 2.17% |
Present value (millions of dollars) discounted at 7.5% | $189 | $190 | $178 | $172 | $165 | $158 | $151 | $143 | $136 | $130 |
(“East” = FCF growth rate estimated by Simply Wall St)
10-year discounted cash flow (PVCF) = $1.6 billion
The second stage is also known as the terminal value, it is the cash flow of the business after the first stage. 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 7.5%.
Terminal value (TV)= FCF_{2032} × (1 + g) ÷ (r – g) = US$266 million × (1 + 2.0%) ÷ (7.5%–2.0%) = US$5.0 billion
Present value of terminal value (PVTV)= TV / (1 + r)^{ten}= $5.0 billion ÷ (1 + 7.5%)^{ten}= $2.4 billion
The total value, or equity value, is then the sum of the present value of future cash flows, which in this case is $4.0 billion. The final step is to divide the equity value by the number of shares outstanding. Compared to the current share price of $49.6, the company appears to be pretty good value at a 47% discount to the current share price. Remember though that this is only a rough estimate, and like any complex formula – trash in, trash out.
The hypotheses
The above calculation is highly dependent on two assumptions. One is the discount rate and the other is the cash flows. You don’t have to agree with these entries, I recommend that you redo the calculations yourself and play around 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 Progress 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) which factors in debt. In this calculation, we used 7.5%, which is based on a leveraged beta of 1.169. 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.
SWOT analysis for Progress software
- Debt is well covered by earnings and cash flow.
- Dividends are covered by earnings and cash flow.
- Earnings growth over the past year has underperformed the software industry.
- The dividend is low compared to the top 25% dividend payers in the software market.
- Annual revenues are expected to increase over the next 3 years.
- Trading below our estimate of fair value by more than 20%.
- Annual earnings are expected to grow more slowly than the US market.
Look forward:
Valuation is only one side of the coin in terms of crafting your investment thesis, and it shouldn’t be the only metric you look at when researching a company. It is not possible to obtain an infallible valuation with a DCF model. Preferably, you would apply different cases and assumptions and see their impact on the valuation of the business. If a company grows at a different rate, or if its cost of equity or risk-free rate changes sharply, output may be very different. Why is intrinsic value higher than the current stock price? For Progress Software, we’ve put together three relevant aspects you should explore:
- Risks: For example, we have identified 1 warning sign for Progress Software of which you should be aware.
- Future earnings: How does the growth rate of PRGS 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 else you might be missing!
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 just search here.
Valuation is complex, but we help make it simple.
Find out if Progress software is potentially overvalued or undervalued by viewing our full analysis, which includes fair value estimates, risks and warnings, dividends, insider trading and financial health.
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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.