RingCentral, Inc. (NYSE: RNG) Shares May Be 20% More Than Estimated Embedded Value
Does the July share price for RingCentral, Inc. (NYSE: RNG) reflect its true value? Today we’re going to estimate the intrinsic value of the stock 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 will see in our example!
We generally believe that the value of a business is the present value of all the cash it will generate in the future. However, a DCF is only one evaluation measure among many, and it is not without its flaws. 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 model.
See our latest review for RingCentral
We are going to use a two-step 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 “steady growth”. To begin with, we need to get cash flow estimates for the next ten years. Where possible, we use analyst estimates, but when these are not available, we extrapolate the previous free cash flow (FCF) from the last estimate or stated 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 down more in the early years than in subsequent years.
In general, 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 the present value:
10-year Free Cash Flow (FCF) estimate
|Leverage FCF ($, Millions)||US $ 118.8 million||204.2 million US dollars||US $ 436.8 million||US $ 653.6 million||US $ 824.9 million||US $ 981.2 million||US $ 1.12 billion||US $ 1.23 billion||US $ 1.33 billion||US $ 1.41 billion|
|Source of growth rate estimate||Analyst x13||Analyst x4||Analyst x1||Analyst x1||East @ 26.21%||Est @ 18.95%||East @ 13.86%||Is 10.3%||Est @ 7.81%||Est @ 6.06%|
|Present value (in millions of dollars) discounted at 6.6%||US $ 111||180 USD||$ 361||US $ 506||US $ 600||US $ 669||US $ 715||US $ 740||US $ 748||US $ 745|
(“East” = FCF growth rate estimated by Simply Wall St)
10-year present value of cash flows (PVCF) = US $ 5.4 billion
The second stage is also known as terminal value, this is the cash flow of the business after the first stage. For a number of reasons, a very conservative growth rate is used that 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 (2.0%) to estimate future growth. Similar to the 10-year “growth” period, we discount future cash flows to their present value, using a cost of equity of 6.6%.
Terminal value (TV)= FCF2031 × (1 + g) ÷ (r – g) = US $ 1.4 billion × (1 + 2.0%) ÷ (6.6% – 2.0%) = US $ 31 billion
Present value of terminal value (PVTV)= TV / (1 + r)ten= US $ 31 billion ÷ (1 + 6.6%)ten= US $ 17 billion
Total value, or net worth, is then the sum of the present value of future cash flows, which in this case is US $ 22 billion. To get the intrinsic value per share, we divide it by the total number of shares outstanding. Compared to the current share price of US $ 290, the company appears to be slightly overvalued at the time of writing. The assumptions in any calculation have a big impact on the valuation, so it’s best to take this as a rough estimate, not precise down to the last penny.
Now 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 entries, I recommend that you redo the calculations yourself and play 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 full picture of a company’s potential performance. Since we view RingCentral 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 into account debt. In this calculation, we used 6.6%, which is based on a leveraged beta of 0.973. Beta is a measure of the volatility of a stock relative to the market as a whole. We get our beta from the industry average beta from globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.
To move on :
While a business valuation is important, ideally it won’t be the only analysis you review for a business. It is not possible to achieve a rock-solid 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 undervaluation or overvaluation of the company. For example, changes in the company’s cost of equity or the risk-free rate can have a significant impact on valuation. What is the reason why the stock price exceeds intrinsic value? For RingCentral, there are three other factors you should research further:
- Risks: You should be aware of the 3 warning signs for RingCentral we found out before considering an investment in the business.
- Future benefits: How does RNG’s growth rate compare to that of its peers and the broader market? Dig deeper into the analyst consensus count for years to come by interacting with our free analyst growth expectations chart.
- Other strong companies: Low debt, high returns on equity and good past performance are fundamental to a strong business. Why not explore our interactive list of stocks with solid trading fundamentals to see if there are other companies you may not have considered!
PS. Simply Wall St updates its DCF calculation for every US stock every day, so if you want to find the intrinsic value of any other stock just search here.
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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in the mentioned stocks.
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