Using the 2 Stage Free Cash Flow to Equity, DigitalOcean Holdings fair value estimate is US$40.92
DigitalOcean Holdings' US$35.53 share price indicates it is trading at similar levels as its fair value estimate
Our fair value estimate is 5.3% higher than DigitalOcean Holdings' analyst price target of US$38.87
Today we will run through one way of estimating the intrinsic value of DigitalOcean Holdings, Inc. (NYSE:DOCN) by taking the expected future cash flows and discounting them to their present value. One way to achieve this is by employing the Discounted Cash Flow (DCF) model. Before you think you won't be able to understand it, just read on! It's actually much less complex than you'd imagine.
We would caution that there are many ways of valuing a company and, like the DCF, each technique has advantages and disadvantages in certain scenarios. If you still have some burning questions about this type of valuation, take a look at the Simply Wall St analysis model.
Crunching The Numbers
We use what is known as a 2-stage model, which simply means we have two different periods of growth rates for the company's cash flows. Generally the first stage is higher growth, and the second stage is a lower growth phase. To begin with, we have to get estimates of the next ten years of cash flows. Where possible we use analyst estimates, but when these aren't available we extrapolate the previous free cash flow (FCF) from the last estimate or reported value. We assume companies with shrinking free cash flow will slow their rate of shrinkage, and that companies with growing free cash flow will see their growth rate slow, over this period. We do this to reflect that growth tends to slow more in the early years than it does in later years.
Generally we assume that a dollar today is more valuable than a dollar in the future, so we need to discount the sum of these future cash flows to arrive at a present value estimate:
10-year free cash flow (FCF) estimate
2024
2025
2026
2027
2028
2029
2030
2031
2032
2033
Levered FCF ($, Millions)
US$153.0m
US$178.2m
US$209.0m
US$231.9m
US$251.4m
US$268.0m
US$282.2m
US$294.8m
US$306.1m
US$316.4m
Growth Rate Estimate Source
Analyst x5
Analyst x6
Analyst x1
Est @ 10.97%
Est @ 8.39%
Est @ 6.59%
Est @ 5.33%
Est @ 4.44%
Est @ 3.82%
Est @ 3.39%
Present Value ($, Millions) Discounted @ 8.8%
US$141
US$151
US$162
US$166
US$165
US$162
US$157
US$151
US$144
US$137
("Est" = FCF growth rate estimated by Simply Wall St) Present Value of 10-year Cash Flow (PVCF) = US$1.5b
The second stage is also known as Terminal Value, this is the business's cash flow 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 have used the 5-year average of the 10-year government bond yield (2.4%) to estimate future growth. In the same way as with the 10-year 'growth' period, we discount future cash flows to today's value, using a cost of equity of 8.8%.
Present Value of Terminal Value (PVTV)= TV / (1 + r)10= US$5.1b÷ ( 1 + 8.8%)10= US$2.2b
The total value is the sum of cash flows for the next ten years plus the discounted terminal value, which results in the Total Equity Value, which in this case is US$3.7b. To get the intrinsic value per share, we divide this by the total number of shares outstanding. Relative to the current share price of US$35.5, the company appears about fair value at a 13% discount to where the stock price trades currently. Remember though, that this is just an approximate valuation, and like any complex formula - garbage in, garbage out.
NYSE:DOCN Discounted Cash Flow May 2nd 2024
The Assumptions
The calculation above is very dependent on two assumptions. The first is the discount rate and the other is the cash flows. You don't have to agree with these inputs, I recommend redoing the calculations yourself and playing with them. 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 DigitalOcean Holdings 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 8.8%, which is based on a levered beta of 1.385. 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 DigitalOcean Holdings
Strength
Debt is well covered by earnings.
Balance sheet summary for DOCN.
Weakness
Shareholders have been diluted in the past year.
Opportunity
Annual earnings are forecast to grow faster than the American market.
Current share price is below our estimate of fair value.
Threat
Debt is not well covered by operating cash flow.
Total liabilities exceed total assets, which raises the risk of financial distress.
Revenue is forecast to grow slower than 20% per year.
Is DOCN well equipped to handle threats?
Moving On:
Although the valuation of a company is important, it is only one of many factors that you need to assess for a company. It's not possible to obtain a foolproof valuation with a DCF model. 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 instance, if the terminal value growth rate is adjusted slightly, it can dramatically alter the overall result. For DigitalOcean Holdings, we've put together three essential elements you should look at:
Risks: As an example, we've found 4 warning signs for DigitalOcean Holdings (2 make us uncomfortable!) that you need to consider before investing here.
Future Earnings: How does DOCN'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.
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. 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.
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.
