Estimating The Intrinsic Value Of Paycom Software, Inc. (NYSE:PAYC)

Estimating The Intrinsic Value Of Paycom Software, Inc.  (NYSE:PAYC)

Key Insights

  • Using the 2 Stage Free Cash Flow to Equity, Paycom Software’s fair value estimate is US$315

  • Paycom Software’s US$269 share price indicates it is trading at similar levels as its fair value estimate

  • The US$371 analyst price target for PAYC is 18% more than our estimate of fair value

In this article we are going to estimate the intrinsic value of Paycom Software, Inc. (NYSE:PAYC) by taking the expected future cash flows and discounting them to today’s value. This will be done using the Discounted Cash Flow (DCF) model. It may sound complicated, but actually it’s quite simple!

Remember though, that there are many ways to estimate a company’s value, and a DCF is just one method. Anyone interested in learning a bit more about intrinsic value should have a read of the Simply Wall St analysis model.

Check out our latest analysis for Paycom Software

The Method

We use what is known as a 2-stage model, which simply means 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 phase. To start off with, we need to estimate the next ten years of cash flows. Where possible we use analyst estimates, but when these aren’t available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with reduced free cash flow will slow their rate of depreciation, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.

Generally we assume that a dollar today is more valuable than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at a present value estimate:

10-year free cash flow (FCF) forecast

2023

2024

2025

2026

2027

2028

2029

2030

2031

2032

Leveraged FCF ($, Millions)

US$306.3m

US$416.3m

US$581.9m

US$741.3m

US$890.9m

US$1.00b

US$1.10b

US$1.17b

US$1.24b

US$1.30b

Growth Rate Estimate Source

Analyst x13

Analyst x12

Analyst x4

Analysts x2

Analysts x2

Est @ 12.45%

Est @ 9.35%

Est @ 7.17%

Est @ 5.66%

Est @ 4.59%

Present Value ($, Millions) Discounted @ 7.3%

US$285

US$362

US$471

US$559

US$626

US$656

US$669

US$668

US$658

US$641

(“Est” = FCF growth rate estimated by Simply Wall St)
Present Value of 10-year Cash Flow (PVCF) = US$5.6b

After calculating the present value of future cash flows in the initial 10-year period, we need to calculate the Terminal Value, which accounts for all future cash flows beyond 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 2.1%. We discount the terminal cash flows to today’s value at a cost of equity of 7.3%.

Terminal Value (TV)= FCF2032 × (1 + g) ÷ (r – g) = US$1.3b× (1 + 2.1%) ÷ (7.3%– 2.1%) = US$26b

Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$26b÷ ( 1 + 7.3%)10= US$13b

The total value, or equity value, is then the sum of the present value of the future cash flows, which in this case is US$18b. The last step is to then divide the equity value by the number of outstanding shares. Relative to the current share price of US$269, the company appears about fair value at a 15% discount to where the stock price trades currently. The assumptions in any calculation have a big impact on the valuation, so it is better to view this as a rough estimate, not precise down to the last cent.

dcf

dcf

Important Assumptions

We would point out that the most important inputs to a discounted cash flow are the discount rate and of course the actual cash flows. Part of investing is coming up with your own evaluation of a company’s future performance, so try the calculations yourself and check your own assumptions. The DCF also does not consider the possible cyclicality of an industry, or a company’s future capital requirements, so it does not give a full picture of a company’s potential performance. Given that we are looking at Paycom 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 accounts for debt. In this calculation we’ve used 7.3%, which is based on a leveraged beta of 0.873. Beta is a measure of a stock’s volatility, compared to the market as a whole. We get our beta from the industry average beta of globally comparable companies, with an imposed limit between 0.8 and 2.0, which is a reasonable range for a stable business.

SWOT Analysis for Paycom Software

strength

Weaknesses

Opportunities

Threats

Looking Ahead:

While important, the DCF calculation ideally won’t be the sole piece of analysis you scrutinize for a company. The DCF model is not a perfect stock valuation tool. Instead the best use for 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, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For Paycom Software, we’ve compiled three pertinent aspects you should assess:

  1. risks: Be aware that Paycom Software is showing 1 warning sign in our investment analysis you should know about…

  2. Future Earnings: How does PAYC’s growth rate compare to its peers and the wider market? Dig deeper into the analyst consensus number for the upcoming years by interacting with our free analyst growth expectation chart.

  3. 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 is out there you may be missing!

PS. The Simply Wall St app conducts a discounted cash flow valuation for every stock on the NYSE every day. If you want to find the calculation for other stocks, just search here.

Have feedback on this article? Concerned about the content? get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by 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 to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.

Join A Paid User Research Session
You’ll receive a US$30 Amazon Gift Card for 1 hour of your time while helping us build better investing tools for the individual investors like yourself. Sign up here