Does the October share price for ServiceNow, Inc. reflect (NYSE:NOW) what is it really worth? Now, we will estimate the intrinsic value of the stock by estimating the company’s future cash flows and reducing them to their present value. We will take advantage of the Discounted Cash Flow (DCF) model for this purpose. Don’t be put off by the jargon, the math behind it is really straightforward.
We would caution that there are many ways to value a company and, like DCF, each method has advantages and disadvantages in certain situations. If you still have some burning questions about this type of valuation, check out the Simply Wall St. evaluation model.
Check out our latest review for ServiceNow
Is ServiceNow Fairly Valued?
We use what is known as a 2-stage model, which simply means that we have two different periods of growth rates for the company’s cash flows. Generally the first stage is higher growth, and the second stage is a lower growth stage. To begin, we need to obtain estimates of the next ten years of cash flows. Where possible, we use analyst estimates, but when they are not available, we extrapolate past free cash flow (FCF) from the last estimate or reported value. We assume that companies with decreasing free cash flow will slow their rate of contraction, and companies with growing free cash flow will see their growth rate slow, during this period. We do this to show that growth is slower in the early years than in later years.
In general, we assume that a dollar today is worth more than a dollar in the future, so we reduce the value of 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 | |
| Leveraged FCF ($, Million) | US$2.81b | US$3.63b | US$4.19b | US$5.13b | US$5.82b | US$6.40b | US$6.89b | US$7.30b | US$7.65b | US$7.95b |
| Source of Estimated Growth Rate | Analyst x24 | Analyst x14 | Analyst x4 | Analyst x3 | Approx @ 13.5% | Approx @ 10.05% | Approx @ 7.63% | Approx @ 5.93% | Approx @ 4.75% | Approx @ 3.92% |
| Present Value ($, Millions) discounted @ 6.8% | US$2.6k | US$3.2k | US$3.4k | US$3.9k | US$4.2k | US$4.3k | US$4.4k | US$4.3k | US$4.2k | US$4.1k |
(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$39b
We now need to calculate the Terminal Value, which accounts for all future cash flows after these ten years. The Gordon Growth formula is used to calculate the Terminal Value at a future annual growth rate equal to the 5-year average of the 10-year government bond yield of 2.0%. We discount the terminal cash flows to today’s value at an equity value of 6.8%.
Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$7.9b× (1 + 2.0%) ÷ (6.8%– 2.0%) = US$170b
Present Value Terminal Value (PVTV)= TV / (1 + r)10= US$170b÷ ( 1 + 6.8%)10= US$88b
Total value, or equity value, is the sum of the present value of future cash flows, which in this case is US$127b. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Relative to the current share price of US$342, the company appears to be somewhat undervalued at a 46% discount to where the stock price is currently trading. Assumptions in any calculation have a big impact on the valuation, so it’s better to look at it as a rough estimate, not accurate to the last cent.
The Assumptions
We point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flow. You don’t have to agree with these inputs, I recommend re-doing the calculations and playing with them. DCF also does not take into account the possible cyclicality of an industry, or the future capital requirements of a company, so it does not provide a full picture of a company’s potential performance. Because we are looking at ServiceNow as potential shareholders, the value of equity is used as the discount rate, rather than the cost of capital (or weighted average cost of capital, WACC) that defines debt. In this calculation, we used 6.8%, which is based on a levered beta of 1.021. Beta is a measure of the volatility of a stock, compared to the market as a whole. We derive our beta from the industry average beta of comparable companies worldwide, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
SWOT analysis for ServiceNow
- Debt is not viewed as a risk.
- Revenue growth over the past year has underperformed the Software industry.
- Annual revenues are expected to grow faster than the American market.
- Good value based on P/S ratio and estimated fair value.
- Revenue is expected to grow slower than 20% per year.
Moving On:
While a company’s valuation is important, it shouldn’t be the only metric you look at when researching a company. 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 rate, or if its cost of equity or risk free rate changes dramatically, the output may look very different. What is the reason for the share price sitting below the intrinsic value? For ServiceNow, we’ve put together three additional factors you should consider:
- Risks: Every company has them, and we found 1 warning for ServiceNow you should know about.
- Management:Are insiders raising their shares to take advantage of market sentiment for NOW’s future outlook? See our management and board analysis with insights into CEO compensation and governance factors.
- Other High Quality Alternatives: Do you want a good all-rounder? Explore our interactive list of high-quality stocks to get an idea of what else is out there that you might be missing!
P.S. Simply Wall St updates its DCF calculation for every American stock every day, so if you want to find the intrinsic value of any other stock, just search here.
Valuation is complicated, but we help make it simple.
Find out if Service Today is potentially over- or under-priced by checking out our comprehensive review, which includes fair value estimates, risks and caveats, dividends, insider transactions and financial health.
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This Simply Wall St article is general. We provide commentary based on historical data and analyst forecasts using only an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take into account your goals, or your financial situation. We aim to bring you long-term focused analysis driven by primary data. Note that our review may not factor in the company’s latest price-sensitive or material quality announcements. Simply Wall St has no position in any of the stocks mentioned.